Minsky moment: are pension assets at risk due to flawed climate analysis?

Pension funds are risking the retirement savings of millions of people by relying on economic research that simply ignores critical scientific evidence about the financial risks embedded within a warming climate.

In fact, financial institutions, central banks, regulators as well as governments underestimate the riskis and economic damages of climate change, relying too heavily on research from a small, self-referential group of climate economists that do not take into account the impact of so-called climate ‘tipping points’.

At least, that is the alarming message from Professor Steve Keen and the financial think tank Carbon Tracker.

They argue that many pension funds use investment models that predict global warming of 2 to 4.3°C will have only a minimal impact on member portfolios, based on economists “flawed estimates” of damages from climate change, which predict that even with 5 to 7°C of global warming, economic growth will continue.

Keen underscores that such economic studies cannot be reconciled with warnings from climate scientists that global warming on this scale would be “an existential threat to human civilisation.”

Economist Keen, currently a research fellow at University College of London in the UK, argued that just as mainstream economists failed to predict the global financial crisis in 2008 – the worst economic crisis since the Great Depression – they could now be steering the world toward another crash.

Keen added that “global warming is not a minor cost-benefit problem that will mainly affect future generations, as the economic literature asserts, but a potentially existential threat to the economy, on a timescale that could occur within the lifespan of pensioners alive today."

“We are talking about the financial futures of millions of people.”

Tipping points

Scientists warned last year that several tipping points risk being triggered in the next decade.

For example, loss of winter ice in the Barents Sea and collapse of deep convection in the Labrador Sea could lead to more extreme seasonal weather in Europe, worse than experienced during the Ice Age, with significant sea level rise on the northeast seaboard of the USA.

These 'tipping points' are not taken into account in the economic studies currently relied on by many mainstream investment models as used by financial institutions, as highlighted in a recent report by the Institute and Faculty of Actuaries (IFoA) and the University of Exeter.

The report warned for “scientifically false assumptions” by climate economists persist because their studies are typically peer-reviewed only by other economists, and fail to incorporate key science.

This practice ignores the likelihood of predicted triggering “tipping points” that accelerate economic damage, the researchers warned.

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Widespread reliance on flawed research generates a disconnect between current investment decision making, which assumes relatively trivial impacts from climate change, and the likely real-world effects of global warming, Keen warned.

"To ensure that the world moves into a new climate secure energy system, it’s crucial pension schemes send the market the right investment signals,” said Mark Campanale, the founder of Carbon Tracker.

“The signal has to be that a swift, orderly transition is in everyone’s financial interests, particularly for scheme beneficiaries.”

However, the relationship between economics, climate science and assessing financial risk is not a “comfortable one,” he continued, adding that “the advice pension schemes are receiving risks trivialising the potentially huge damage climate change will have to asset values."

Campanale stressed that “these flawed climate risk models” are used throughout the financial system, lulling economic decision makers, from pension funds to central banks, into a false sense of security.

“The result is cavalier positions such as US Federal Reserve Board Governor Christopher Waller who announced: ‘Climate change is real, but I do not believe it poses a serious risk to the safety and soundness of large banks or the financial stability of the United States’,” he said.

‘Climate Minsky moment’

The report issues a direct warning to asset owners for the serious prospect of an “unpleasant, abrupt and wealth destroying” so-called “Climate Minsky moment” with a sudden collapse in asset values as financial markets wake up to the gap between mainstream economist forecasts and the reality of climate impacts.

Keen, who is also the former head of the School of Economics, History and Politics at Kingston University, London, contrasts scientists’ empirical research with predictions by climate economists that are “a ‘hunch’ based on rather spurious assumptions for global warming, which have been used to generate equally spurious estimates of damages to future GDP.”

He underscored that global warming, at less than 1.5°C, is already affecting people and companies across the planet, pointing at record heatwaves, floods, and intensifying storms as they halt commerce, damage crops, create uninsurable areas, and impair infrastructure.

Keen singled out scientific research which finds that exceeding the 1.5°C Paris target would be “dangerous”, passing 3°C would be “catastrophic”, and reaching 5°C will be “beyond catastrophic, raising existential threats”.

Yet, despite scientific predictions, a survey of 738 climate economics papers in a number of top academic journals found the median prediction of economists was that 3°C of warming would reduce global GDP by just 5%, and warming of 5°C would see a 10% reduction.

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Nobel prize-winning economist William Nordhaus is even more sanguine, predicting that a 3°C rise would reduce global income by only 2% and 6°C by 7.9%, compared to what it would have been in the complete absence of global warming.

While climate scientists and some leading economists, such as Nicholas Stern and Joseph Stiglitz, have challenged the inadequate climate risk models used in economic reports, the majority of economists have not aligned their reports with climate science.

Investment managers

The researchers singled out investment managers and consultants such as Aon Hewitt, Hymans Robertson and Mercer as they "continue to rely on flawed research" when they advise pension funds on the impacts of global warming on members’ portfolios.

For example, Mercer,  in advice to Australian fund HESTA predicts only a -17% portfolio impact by 2100 in a 4°C scenario. It states that its model primarily reflects coastal flood damage and does not take account of climate tipping points.

Mercer also advises LGPS Central, which manages £28.5 billion of retirement savings for a million members of Local Government Pension Schemes in the UK.

One of these schemes, Shropshire County Pension Fund, told members that a trajectory leading to 4°C by 2100 would only reduce annual returns by 0.06% in 2030 and 0.1% by 2050, saying that it relied on LGPS Central for information.

Moreover, in a 2022 report, Australian superannuation firm Unisuper concluded that even in a “worst case scenario” involving a 4.3°C increase in global temperatures by 2100, “the overall risk to our portfolio is acceptable.”

“Each layer in the process of assessing the risks of climate change has assumed that the previous layer has done its job adequately, and has relied on the previous layers reputation, rather than scrutiny of the work undertaken," explained Professor Keen.

“Pension funds rely upon consultants because of their reputation in the field; consultants rely upon academic economists, because their papers had passed academic refereeing,” he added.

“The final impact is a series of flawed economic assumptions informing pensions’ decision making.”

Financial market participants

According to Keen, flawed mainstream economic studies also influence global economic policy, such as the Financial Stability Board (FSB) predicting that a 4°C rise in global temperatures would reduce global asset prices by 3-10%.

Most financial market participants accept figures from the FSB, NGFS, and consulting firms like Mercer as accurate so “it is highly likely that stock market valuations are wildly out of step with the future course of stock prices, dividends and GDP in a climate-changed world,” he continued.

“Financial regulators must drastically revise the stress tests they use to test the exposure of financial institutions to climate change,” Keen stressed.

“These predictions of the minimal economic impact of global warming of 2 - 4.3°C are representative of the advice being given by pension funds worldwide to their members,” he added.

Pension funds have a fiduciary duty to correct the methodologies on which they rely, as well as the information they have given clients.

It contained “a call to all stakeholders, from governments, regulators, investment professionals, all the way to civil society groups and individuals, to ensure that the critical error of taking this unsound [economic] research seriously is reversed, before it is too late," Keen concluded.

Net Zero Investor has approached Mercer for a response.

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