Models and Climate Risk

I was talking to a wind Farmer, met him at CogX Festival and was fascinating to know how easy it is to get into the business of wind farming in UK! You lease a piece of land that 'does no harm' or a willing farmer who would collect rent, wind turbine installation companies run the day to day of the operations so no hassles there and then you wait for the WIND! to blow....I asked him where does your business usually get stuck - there must be a challenge when you are starting out. I was informed that its usually the insurance company because they are underwriting while the rules of the game are changing daily. I asked "How?", my esteemed companion stated "Well its the 'cost of risk' that takes a long while. Everyday weather is changing and the long term climate change impact is being felt and utilized in everyday operational underwriting". and then he got busy on his phone to discuss with his insurer more favorable terms. In the middle of the conversation he turned around, looked annoyed and asked "know anything about modelling? they are saying the parameters are to be changed and pricing done again because new data is released for the region". I nodded and smiled.

Got me thinking - the world of modelling is so deep and wide that its a strange paradigm to deal with if you are a customer or party impacted but in the finance and risk industry we play with models as if our life depends on them. You cannot manage what you can not measure and you can not project what you have not 'if-ed' in a scenario! Models are quiet often layered and back to back unpacked through complex mathematics and unfamiliar jargon, and accompanied with its list of assumptions. oh yeah! assumptions are very important, you see no one has the crystal ball to predict. only data and projections. Models are robust yet vulnerable to errors and change. They do keep you at your best scenario for planning and preparedness. 

When it comes to Climate Risk we have many hoops to jump and recognize, here is my attempt to give a very high level interaction between various model frameworks and how their outputs are utilized in other models. I will keep it simple.

We start at the grandfather level, the apex - Global Climate model and then bring it down to the very specific sector risk calculation for a business through Risk Models and the many layers in between and their interrelationship.

Models such as Global Climate Models (GCMs), Climate Risk Models, Integrated Assessment Models (IAMs), Economic Models, and Risk Models and interrelationship between them - is complex, as these models are used to understand and analyze various aspects of climate change and its impacts. Here's a brief overview of how they relate to each other: 

1. Global Climate Models (GCMs): - GCMs are complex mathematical representations of the Earth's climate system. They simulate physical processes such as temperature, precipitation, wind patterns, and atmospheric composition.- GCMs provide data on future climate scenarios, including changes in temperature, sea levels, and precipitation patterns under different greenhouse gas emissions scenarios.

2. Climate Risk Models (CRMs):- Climate Risk Models are used to assess the potential impacts of climate change on various sectors, including agriculture, infrastructure, and insurance.- These models use data from GCMs to project climate-related risks, such as extreme weather events, sea-level rise, and temperature increases, and assess their potential economic and societal consequences- CRM will blend a GCM and CAT model to work on a scenario. A CAT model is a catastrophe model that looks at extreme weather events/natural disasters (used quite often in Insurance industry)

3. Integrated Assessment Models (IAMs): - IAMs are central to IPCC reports and the goal to hold global warming well below 2˚C and pursue efforts to limit this warming to 1.5˚C above pre-industrial.- IAMs are comprehensive models that integrate information from various domains, including economics, energy, and the environment.- They combine data from GCMs and Climate Risk Models with economic and social data to assess the costs and benefits of climate change mitigation and adaptation strategies.

4. Economic Models (EMs):- Economic Models are used to evaluate the economic impacts of climate change and climate policies.- These models take input from IAMs to assess the costs of reducing greenhouse gas emissions, the economic benefits of avoiding climate-related damages, and the optimal allocation of resources for mitigation and adaptation efforts.

5. Risk Models (RMs)- Risk Models, in the context of climate change, are designed to quantify the financial and non-financial risks associated with climate-related events and changes.- They often utilize data from Climate Risk Models and Economic Models to estimate potential losses, liabilities, and impacts on financial markets and portfolios.- Try to project the potential exposure of a region, sector or organisation to climate change and its impacts through physical and transition risk transmission channels.

Actually in summary, these models are interconnected and work together to provide a comprehensive understanding of the complex relationship between climate change, its impacts, and the economic and societal responses to mitigate and adapt to these changes. They play a crucial role in informing policy decisions and helping stakeholders assess the risks and opportunities associated with climate change. this illustration may give you a simple view of their interrelationship:

that is,

• GCMs provide the foundational climate data used by Climate Risk Models to project future climate scenarios.

• Climate Risk Models inform IAMs about the potential physical risks and damages associated with climate change.

• IAMs integrate information from GCMs and Climate Risk Models to evaluate the economic and societal implications of climate change and climate policies.

• Economic Models use IAM output to assess the economic aspects of climate change and climate policies.

• Risk Models incorporate information from Climate Risk Models, Economic Models, and IAMs to quantify financial and non-financial risks associated with climate change.Now if you want to further fall down the rabbit hole, ie as a finance and risk professional who wants to explore and quantify the impacts of the changing climate under a range of different assumptions, you would need Physical Risk modelling (read the box below!) both across quantitative and qualitative 

The basic framework for modelling physical risks can be broken down into the following areas:
1. Consider this - Events that occur with an unpredictable probability.  for example, hurricanes in USA. each event is defined by a specific strength or size, location or path, and probability of occurring. Thousands of possible event scenarios are simulated based on realistic parameters and historical data to probabilistically model what could happen over time.
2. Consider this - Account for factors that might cause or exacerbate a potential loss across an at-risk geographical area. This might include the strength of the winds around a storm together with the affected region’s terrain and built environment.
3. Consider this - describes the potential impact of a hazard on an asset, for example, by calculating the amount of expected damage. Vulnerability is region-specific and varies by an asset’s susceptibility to damage based on, in the case of a building for example, its size and height, construction material, occupancy type and year of construction. A vulnerability module also estimates business interruption and similar losses beyond physical damage.
4. Consider now the financial impacts by looking beyond the immediate physical damage and examining the impacts of business, supply chain and distribution disruption, as well as the longer-term financial impacts associated with restoring social and physical infrastructure such as power, water, sanitation, healthcare and education. 

 This allows organisations to consider current losses, how these will change in the future, and how mitigation or other actions may reduce the impact of climate risk. 

Did you find this useful?