Since 2006, the World Economic Forum’s “Global Risks” report has presented an analysis of risks that are shaping the global environment. Its 2011 report provided a high level overview of 37 selected global risks as seen by members of the World Economic Forum’s Global Agenda Councils and supported by a survey of 580 leaders and experts around the world.
In the World Economic Forum’s view, a “global risk” is defined as having global geographic scope, cross-industry relevance, uncertainty as to how and when it will occur and high levels of economic and/or social impact, including the potential to cause economic damage of $10bn or more. This survey measured the perception of risk likelihood, risk impact (in dollars) and risk interconnections from 2010 to 2020, categorised into economic, environment, societal and geopolitical threats.
Among the top ten global risks identified by the experts were fiscal crises, wars and global corruption. However, ranked the very highest when likelihood and impact were combined was climate change.
This is interesting because there is a well known bias in risk perception: respondents to surveys in general tend to inflate the impact of risks which involve extreme “shocks”, such as the terrorism of 9/11, bird flu in Hong Kong or the current uprisings in the Middle East. They tend to discount the impact of risks which are gradual and long term.
Nevertheless, climate change though defined explicitly in these latter terms in the World Economic Forum’s survey, was seen as the greatest global challenge facing the world. It should also be noted that other risks which were counted in the top ten list included energy price volatility, storms and cyclones, flooding and water security - all events that may be closely linked with climate change.
In the World Economic Forum’s analysis, the increasingly connected economic, commercial and political systems around the world are contributing greatly to the scale of potential risk impacts. This concern is echoed by New York University professor, Nassim Taleb, who popularised the notion of “black swans”, or highly improbable, devastating events. In his best-selling book of that name, he wrote: “Globalisation creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating black swans.”
Natural disasters, such as Hurricane Katrina in the US, the recent fires in Russia and Canada, the floods in Pakistan and Australia or last year’s Japanese earthquake and tsunami, are characterised by some analysts as “black swans”, extreme events that were impossible to predict. As rapidly growing populations mean that more and more people living everywhere, the impact of each major event is felt by increasing numbers of people. With economic globalisation and closely interlinked supply chains and markets, each has the potential to impact the world.
Climate scientists have warned that if we cannot begin to stabilise carbon dioxide levels in the atmosphere within the next ten years, there is a very high probability that the world will experience moderate global warming and a smaller, but still real, possibility of passing critical thresholds that will result in significant climate changes. Economic models that claim that the costs of preventing climate change are not worth the benefits of avoided damages are ignoring the possibilities of climate “black swans”, ranging from catastrophic storms, floods or drought to water and food shortages and the civil unrest and social breakdown that these circumstances could bring about.
Although the debate is still continuing, many governments around the world are responding to the challenge of climate mitigation and putting policy frameworks in place to support this, while the international negotiations on a global climate deal are slowly moving forward, following a promising outcome at the Durban talks in December. These developments mean that climate change issues increasingly dominate the risk management agenda for investors and companies.
Findings from Mercer’s recent research report “Climate Change Scenarios - Implications for Strategic Asset Allocation” suggest that domestic and international climate policy could contribute as much as 10% to overall portfolio risk over the next twenty years, depending on the extent to which it is coordinated, transparent and timely. Uncertainty around climate policy is a significant source of risk which investors will need to manage and seek to quantify. Mercer estimates the economic cost of climate policy for the market to absorb could be as much as $8trn by 2030.