The economy is inextricably linked to the physical world.
Economic inputs - labor and capital - require natural resources to operate. Economic output impacts the natural environment.
You might think this is common sense, but most economists, politicians and business leaders have disassociated the world of commerce and government from nature. Instead, they believe humanity can outsmart physics with ingenuity and innovation.
The modern economic system is constructed using the assumption that price mechanisms are enough to stimulate commodity supply responses. It fails to incorporate finite limits. It also fails to model the true costs of negative externalities, like pollution. Consequently, economists and politicians have a flawed understanding of climate change destruction in a language they understand - money.
This is the root of our current biosphere crisis, and its origins began centuries ago.
"Labor without energy is a corpse.
Capital without energy is a statue."
- Steve Keen
The average person could be excused in thinking human prosperity is primarily driven by our ingenuity. Humans have invented many life-altering technologies over the past couple centuries: electricity, the washing machine, cars, planes. But what many don't realize is that each progressive development is simply a new means to convert finite natural resources, labor and stored energy into economic output. The whole system remains dependent on Mother Nature.
This paradigm has existed since the Industrial Revolution, so it's not surprising the models are widely accepted. Moreover, with natural resources plentiful and nature virgin, for many years economic models could ignore these factors. It's only over the past couple decades that physical reality began catching up to the old ways of thinking.
Scientists are shouting from the rooftops about rising global temperatures and climate destruction. Meanwhile, economists and policy makers have been led astray by old world thinking. Mother Nature's contribution as an input and the negative externalities of our production are both systematically underestimated by the mainstream economics profession. This underestimation also works in reverse.
The same models that underestimate the link between mother nature and the economy, underestimate the devastation climate change will have on economic output.
This disconnect is critical to understanding why governments and industry fail to act on climate change. Reliance on traditional economic models gives the impression climate change will have a minimal impact on the economy and government tax base.
Further exacerbating this, mainstream financial modeling guiding policy is premised off a naïve view of the world. One that assumes change isn't discontinuous and fails to incorporate the pro-cyclicality of physical and financial systems.
This is not new. The world of economics and finance is renowned for insular straight-line forecasting. This is exactly what happened before the global financial system nearly collapsed in 2008/2009. The expected resilience of the system was based on historical norms, ignoring the interconnectedness of financial markets. Incrementalism at its worst. This is a perfect analog for how economic analysts are incorrectly forecasting the impacts of climate change.
In 2008, the globally interconnected financial system disintegrated almost overnight as the Lehman Brothers bankruptcy suddenly revealed a hidden web of dependencies. As a result, the global financial system came within hours of shutting down.
What does that mean? Companies can't make payroll, businesses don't get paid, people can't access their money, food isn't delivered to the grocery store, and so on. Treasury officials begged Congress for massive amounts of money to backstop the financial system, arguing the US was days from martial law if the funds weren't provided.
Long story short, massive amounts of money papered over the losses foregoing financial collapse.
We won't be so lucky when an economic crash is triggered by a multi-breadbasket failure. People will quickly discover they can't eat dollar bills.
Like in the years preceding the global financial crisis, policy makers are being informed by economic experts that climate change will only reduce GDP by single-digits. Some even forecast a POSITIVE impact to GDP.
There is a fundamental knowledge gap. Scientists are screaming that the end is nigh, but when economists equate this to a 2-5% hit to future GDP the news appears sanguine. In fact, it makes the scientists appear fanatical.
Money guides politics. If the money is still flowing and governments are still able to collect taxes (and bribes), why enact dramatic, costly or upsetting policy change? This partly explains why governments and businesses have paid lip-service to climate risks.
Fortunately, there is a group of alternative economic researchers examining the failures of existing models and incorporating a broader range of outcomes that consider feedback loops, tipping points and a future that looks nothing like the past.
Recently, actuaries Sandy Trust, Sanjay Joshi, Professor Tim Lenton, and Jack Oliver shared their work in a study called "The Emperor's New Climate Scenarios".
This report highlights that a more realistic economic projection for the Business as Usual scenario is a 50-73% crash in GDP and asset prices.
Summary: The Emperor's New Climate Scenarios
The disconnect between model predictions and scientific forecasts highlights the need for a paradigm shift in how financial institutions and regulators approach climate change.
These disconnects are exemplified by the estimates climate change will have on GDP.
Estimates from Traditional Economic Thought
- Traditional economists have predicted damages from global warming could be as low as 2% of global economic production for a 3˚C rise in global average surface temperature, with varying impacts for higher temperature increases.
- Models show a wide range of economic impacts from a scenario where the world fails to adequately transition to a low-carbon economy. Some models even suggest economically positive outcomes.
More Realistic Systems-Based Estimates
Current models often exclude critical factors such as climate tipping points and second-order impacts, leading to overly optimistic outcomes that underestimate the true risks of climate change. Enhancing these models is crucial for providing a more accurate assessment of the risks to economic output.
- The NGFS (Network for Greening the Financial System) estimates a reduction in global GDP of 18% by 2100 if current policies remain unchanged, not including impacts related to extreme weather, sea-level rise, or wider societal impacts from migration or conflict.
- Other estimates cited include a severe negative GDP impact of 73% in the event of a failed transition, as projected in a joint paper by the IFoA and Ortec Finance.
- Cambridge Econometrics estimates that a 4˚C temperature rise could result in a 65% negative impact on global GDP by 2100.
- The Thinking Ahead Institute estimates that climate tipping points could cause 50-60% downside to financial assets in a business-as-usual scenario, whereas taking action to transition to a well below 2°C world might lead to a loss of 15%.
The wide range of predictions reflects differences in modeling approaches, assumptions about future emissions, the speed of climate warming, the potential crossing of tipping points, and the level of damages expected from climate change.
A systems-approach to modeling the interconnectivity of human civilization with the biosphere is extremely difficult and highly dependent on the assumptions made. Incorporating negative feedback loops and human irrationality is even more challenging. But one thing is clear: the more comprehensive modeling demonstrates the numbers currently used by politicians, economists and business leaders to create policy are way too optimistic.
The report underscores the urgency of adopting more realistic climate scenarios that account for the full spectrum of potential impacts. Financial institutions, regulators, and policymakers must move beyond the limitations of current models to embrace scenarios that reflect the catastrophic risks of inaction.
The economics profession must become as equally alarmed as scientists if government policy is to make a dent in the crisis that humanity faces.
Actuaries, with their deep expertise in risk analysis and long-term modeling, are uniquely equipped to bridge the gap between economic forecasts and climate science realities. By applying actuarial principles to climate-change scenario analysis, they can expose the weaknesses in current economic models and advocate for more realistic assessments of climate-related risks.
Actuaries' influence in the insurance and pension sectors positions them to significantly impact capital allocation decisions, highlighting the importance of their contribution to developing sustainable financial systems.