We all knew it was coming. We knew that while a pandemic was unlikely to materialize at any specific point in time, it was highly likely — in fact certain — to emerge at some point.
According to the World Economic Forum, the threat of infectious diseases has been a top 10 global risk for years.That moment has arrived, revealing just how unprepared we were for the inevitable.
Behavioural economists have come up with fancy words to explain why: cognitive dissonance, hyperbolic discount functions, normalcy bias. These terms all try to capture the sad reality that we knew a crisis would come, yet did little to prepare. Ultimately the COVID-19 crisis shows us that Investors, companies, and governments need to do more to anticipate tail and mega risks and create actionable strategies to prepare for them.
While attention now is rightfully on the now-crystalized risks of COVID-19, climate-related risks continue to mount, and there is much to learn from current events on how to manage them.
While attention now is rightfully on the now-crystalized risks of COVID-19, climate-related risks continue to mount, and there is much to learn from current events on how to manage them
As to the actual nature of COVID-19 compared to climate risk, there are obviously some differences to acknowledge upfront. Unlike a pandemic, the physical risks of climate change, inevitable in all but degree, will be more of a mix of gradual and sudden impacts. Gradual physical impacts will look like shifting crop production, water scarcity, and potentially climate-driven migration [UN report link]. The sudden impacts like droughts, crop failure, storms, and heatwaves — especially in combination — could generate shocks similar to COVID-19, but most likely on the localised level of individual economies or regions, rather than on a global scale.
But there are also some crucial similarities. COVID-19’s economic and financial impacts come from both the severity of the disease and the forceful societal response that it requires. Climate change’s “transition risks” of regulatory and techno-economic change are often modelled as gradual changes precisely because it is the least financially and economically disruptive path. But there is good reason to believe that the shape of the policy response to climate change will have more in common with a pandemic “lockdown” than is immediately apparent. The speed and severity of policy change may be different, but have no doubt that policymakers will act forcefully in a crisis.
The Principles for Responsible Investing (the PRI) commissioned the Inevitable Policy Response, a policy forecast to help investors anticipate and navigate transition risk, which projects that we are increasingly likely to face abumpy techno-economic and policy ride toward zero greenhouse gas emissions.
As with COVID-19, failure to prepare society for mounting risks simply compounds the severity of the policy change necessary to contain the harm as it manifests. A good pandemic forecast may have foreseen both the health crisis and the fragmented, forceful, and disorderly policy response that has ensued because ofinadequate preparation. Anticipating this dynamic is crucial to being able to take preparatory action and avoid reactive policy and worse outcomes.
As with COVID-19, failure to prepare society for mounting risks simply compounds the severity of the policy change necessary to contain the harm as it manifests
The challenge to preparing for these types of risks are threefold.
The first challenge is believability. It didn’t seem realistic or reasonable to assume that one-third of the global population would be on lockdown due to a pandemic, with industrialized countries’ hospitals testing their limits, U.S. crude oil prices going negative, and skyrocketing unemployment. Alas, this pandemic and the policy response to it has put much of the believability issue to rest in terms of expecting the “unexpected.” Many of the impacts we see now are from the stringent (and, in our view, entirely prudent) policy response to the pandemic and not from the disease itself. So too with climate change. The hope is that today’s once unthinkable crisis expands our horizon on not only the possibility, but the high probability, of large-scale, climate-driven disruption to society, the economy, and the market.
The second challenge is complexity. Climate change, like pandemics, is a complicated challenge, with complex impacts and feedback loops across the economy and investment portfolios. When people are faced with too much complexity,they often revert back to the familiar. For the pandemic, this may have meant imagining some of COVID-19’s public health impacts, but not foreseeing the broader disruptions to commerce, trade, and human capital that would ensue from reactive emergency management. For climate change, analysts revert to base case expectations of continued emissions growth.
The key counterweight to complexity is inevitability. A future with no pandemics, and no pandemic management policy,isn’t actually a believable future anymore, even if understanding the alternative futures is complex. So too with the impacts of climate change, and the societal and political response to it. Scenario analysis is a useful antidote to complexity, helping us to navigate the inevitable. The Bank of England has been leading a process to map out a range of climate economic scenarios on behalf of a network of over 50 central banks and supervisors. These authorities can then stress test banks, insurers, and pensions, including against an abrupt climate “Minsky moment” of sudden market repricing from climate policy, to ensure that the markets take them into account.
Still, while a range of scenarios are useful, the markets still need a base case. What do we actually think is going to happen? To address this, the PRI has commissioned the Forecast Policy Scenario, a scenario rooted in a high-conviction forecast of the likely delayed, forceful, and disruptive policy change that will ensue as technological, cultural, and climate change spring load the politics of climate policy. This analysis is a critical start to giving the market some needed foresight.
Finally, even if you accept the Inevitable Policy Response, and navigate the complexity, what can you actually do?
As this storm passes, we must prepare for the inevitable transition to a zero-carbon economy. The good news is that there is evidence that investors have begun to batten down the hatches.The Inevitable Policy Response has created a ”forecast policy scenario” and a framework to think about and plan for inevitable transition risks. So, on climate, the roadmap is clearer than one might think. PRI now requires members to undertake and disclose climate-related financial analysis in line with the recommendations of the Financial Stability Board’s Taskforce on Climate Related Financial Disclosure. Investors should demand, through coalitions like Climate Action 100+, that the companies they own are resilient to climate risk. Investors can also get ahead of transition risk in their portfolios through pace-setting groupslike the United Nations Net Zero Asset Owner’s Alliance. Ultimately investors can work with the PRI, and broader coalitions like the Investor Agenda for climate change, to be the voice that not only calls out the need to prepare forpandemics and the present and future climate, but also does something about it. Society and the market both benefit from rapid and assertive action that anticipates the harm.
As this storm passes, we must prepare for the inevitable transition to a zero-carbon economy. The good news is that there is evidence that investors have begun to batten down the hatches
An immediate opportunity comes into view. Governments are now on the cusp of initiating rare or even unprecedented fiscal stimulus. We have the opportunity to green that stimulus or shovel money into carbon-intensive sectors and load the economic with further risk. It is a crucial opportunity to minimize the severity of a future carbon lockdown.
This pandemic is a lesson for what happens when we don’t prepare. Let’s make sure climate change isn’t.
This blog first appeared in BusinessGreen.