Finance Watch warns that disconnect between climate science and economic modelling feeds climate inaction

Finance Watch sounds the alarm on the severe disconnect between climate science and the economic modelling shaping economic and financial policy.

  • Flawed economic thinking and a lack of consideration for climate science have led to economists underestimating the impact of climate change on the economy, which feeds inaction in policymaking circles.
  • For economic models to yield meaningful results, they must take into account that losses from climate change will be disruptively large, unpredictable and permanent.
  • Given climate risk is a systemic threat to the financial system and that climate change is fundamentally a fossil fuel problem, a new macroprudential solution is needed to tackle the link between climate change and financial instability.

Brussels, 31 October 2023 – On Saturday 4 November, the Paris Agreement will have been in force for seven years. This is the halfway point on the road to delivering on the promises set out in this legally binding international treaty on climate change.

Ahead of this milestone – and with COP28 only one month away – Finance Watch, the public interest association dedicated to making finance work for the good of society, sounds the alarm on the severe disconnect between climate science and the economic modelling shaping economic and financial policy.

Finance Watch’s latest report underscores a stark reality: we are heading toward a hot house world in which action is taken in some jurisdictions, but not enough, and critical temperature thresholds are being exceeded, leading to severe physical risks, irreversible impacts and disruption of societies.

Climate scientists warn of tipping points triggering around 2°C global warming and catastrophic consequences beyond 3°C. If temperatures reach these levels, it will have a devastating impact on the more than 3 billion people who live in contexts highly vulnerable to climate change.

Looking at these numbers, unprecedented economic disruption would appear inevitable. But current figures estimating the impact of climate change on the economy and on the financial world paint a strangely benign picture.

For example, the Network for Greening the Financial System (NGFS) uses methodology that leads to a conclusion that suggests if the global mean surface temperature increased by about 3.5°C until the end of the century, global output would only fall by 7-14% in 2100. Similarly, a 2020 report by the Financial Stability Board (FSB) predicts that a 4°C increase in temperature would decrease asset value by between 3-10%.

The problem is that economists are modelling climate risk in the same way as traditional financial risk. This means that economic models fail to account for the fact that losses from climate change will be disruptively large, unpredictable and permanent. Tipping points and feedback mechanisms, such as melting permafrost and burning forests, could accelerate losses to levels far above those from recent financial crises.

Such conservative figures are a recipe for inaction in policymaking circles, as the widespread rhetoric legitimised is that of the business-as-usual approach and short-termism: plausibility and effectiveness are sacrificed at the altar.

Thierry Philipponnat, Chief Economist at Finance Watch says, “Economists analysing the impact of climate change must not be complicit, even if unwillingly, in the inaction of policymakers. They have a responsibility to open their eyes to the economic and financial impacts of a hot house world. Producing biased analyses that underestimate future costs is no longer an option. Adapt economic models or they’ll undermine both climate change mitigation and adaptation.”

For economic analyses to yield meaningful results, another important mentality shift needs to happen around the timescale of these exercises. In this report, Finance Watch underlines this point with the one-off scenario exercise to be completed by the European Supervisory Authorities (ESAs), the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) by 2025 at the request of the European Commission.

The stated goal of this scenario analysis is to anticipate shocks to the financial system that could imperil financial institutions, the financial system, or the EU’s ability to achieve its climate goals, as well as reacting quickly to any such adverse shocks. Done well, this analysis can provide actors in the financial sector with credible information with which to make decisions in a hot house world.

The current time horizon of 2030 set for this exercise undermines this objective. While the frequency of extreme weather events is increasing, the risk of fossil fuel assets becoming stranded and economic collapse will not materialise by 2030.

The world is unlikely to reverse its current expansion of fossil fuel consumption before that date and the collapse of economic activity induced by climate change will start being significant by 2050 and accelerate to reach catastrophic levels between 2060 and 2080. As such, Finance Watch argues that the European Commission must immediately call for the time horizon to be extended by several decades beyond 2030.

Given that climate risk constitutes a systemic threat to banks and that climate change is fundamentally a fossil fuel problem, Finance Watch also argues in this report that financial institutions’ stranded fossil fuel assets exposures must be quantified.

Research released by Finance Watch in October 2022 showed that the sixty largest global banks have a total exposure of $1.35 trillion to fossil fuel assets. However, this is just one piece of the puzzle. For a comprehensive view of the risks, this exercise must be extended to insurance companies, pension funds and investment funds.

As financial supervisors are best placed to gather this data, they should be obliged by policymakers to do so. In Europe, this information could be gathered as part of the one-off scenario analysis, and Finance Watch advises the European Commission to ensure this happens.

Quantifying the risk of stranded fossil fuel assets is one thing, but creating legally-binding safeguards to stop stranded fossil fuel assets destabilising the financial system is another.

In 2020, Finance Watch proposed an easy and effective microprudential solution to the problem, which later became known as the one-for-one rule. To the relief of banks and disbelief of academics, regulators, investors and NGOs, European policymakers failed to adopt this simple solution at their disposal.

In this report, Finance Watch proposes a new, macroprudential tool to tackle the link between climate change and financial instability. Given that microprudential solutions to tackle this problem are off the table in the EU for now, this new tool is especially important for this jurisdiction. However, the logic underpinning it can be applied elsewhere.

Finance Watch puts forward a new loan-to-value tool for banks’ exposures to fossil fuels. Once a certain threshold of climate-related risk is reached, a capital surcharge would be triggered. The loan-to-value threshold would be set in proportion to the amount of fossil fuels a bank is exposed to that can be safely exploited within the carbon budget for a given temperature increase.

The report finds that 97% of the world’s fossil fuel reserves would have to be left under the ground if humanity wants to limit global warming to 1.5°C with an 83% probability, 90% to limit global warming to 1.7°C and 77% to limit global warming to 2°C.

Finance Watch recommends taking a 2°C global warming reference and setting the loan-to-value limit at 100%. Finance Watch estimates that the loan-to-value ratio is currently extremely high at 437% and suggests a capital requirement of 12% for the part of existing fossil fuel assets that will become stranded as a practical risk management solution.

It also proposes that macroprudential authorities apply a lending cap or full equity funding (‘one-for-one’ rule) to loans related to new fossil fuel exploration, in line with the International Energy Agency’s (IEA) recommendation not to expand existing fossil fuel reserves.

Such a loan-to-value tool has proven to be effective at managing risk in the real estate market, improving the quality of mortgage loan portfolios and bank capitalisation. Such limits have improved the probability of default on loan repayments, as well as the financial loss for a financial institution if a borrower defaults.

Fossil fuel financing, like real estate financing, is about financing assets. A new loan-to-value tool for climate risk would be simple and effective in a world of asset financing in which the most fundamental rule of risk management is ensuring a reasonable relationship between the amount of financing provided and the economic value of the assets financed.

According to Economist Prof. Steve Keen, a Distinguished Research Fellow at University College of London, and author of Loading the DICE Against Pensions, referenced throughout this report, “My report for Carbon Tracker showed that economists have seriously underestimated the damage that global warming will do to the economy. Finance Watch’s new report shows how regulators, because they trusted economists, are woefully unprepared for the serious damage that climate change will do to financial markets. It suggests financial mechanisms which might enable us to limit warming to only the dangerous levels of 1.5 – 2 degrees Celsius, rather than the catastrophic levels of 3 – 4 degrees which, bizarrely, economists like William Nordhaus have described as ‘optimal'”.

– Ends –

Notes to Editors

Ahead of COP28, the press release for this report is also available in Arabic

To arrange an interview with Thierry Philipponnat, Chief Economist at Finance Watch, and/or Economist Prof. Steve Keen, please contact Alison Burns at or call on +32 (0)471577233

About Thierry Philipponnat, Chief Economist at Finance Watch

After graduating from Institut d’Etudes Politiques de Paris and training as an economist (Master’s degree in economics), Thierry Philipponnat started a career in finance in 1985, holding different positions in commercial and investment banking. He then crossed into the NGO world, campaigning and lobbying on behalf of Amnesty International, with a particular emphasis on corporate social responsibility and on the impact of the financial sector on human rights.

In 2011, he founded Finance Watch, which he managed as its first Secretary General until 2014. In October 2019, Finance Watch appointed Thierry Philipponnat as its Head of Research and Advocacy, and in January 2022 as its Chief Economist.

Philipponnat was a member of the Board of the French Financial Markets Authority (AMF) until 2022 and is currently a member of the Sanctions Committee of the French Banks and Insurance Companies Supervisor (ACPR). He chaired the AMF’s Climate and Sustainable Finance Commission as well as its Market Consultative Commission. He is a member of ACPR’s Climate and Sustainable Finance Commission and of its Scientific Committee. He is also a member of European Financial Reporting Advisory Group’s (EFRAG) Sustainability Reporting Board and formerly a member of the European Commission’s Platform on sustainable finance.

He is the author of numerous books and articles, and regularly offers comment in the media on a wide range of financial topics, appearing in the Financial Times, Al Jazeera, Reuters, Politico, Euractiv, Le Monde and more.

About Finance Watch

Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.


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