This research program aims to integrate the management of these risks, particularly those related to climate change, into financial markets and supervisory practices. In doing so, the program combines a number of current and past research streams, including the Tragedy of the Horizons research project (2015-2017), 2DII’s work on climate and sustainability stress testing, and its broader research initiatives on integrating long-term risk into private sector and government practice.
With COVID-19, we are currently experiencing the materialization of exactly this kind of risk. However, especially given the looming climate crisis, there is reason to believe that these risks will increase in frequency and intensity in the future.
Financial institutions such as insurance companies, pension funds, central banks, regulators and banks are not fully equipped to manage such type of risks. The fundamental uncertainty associated with these risks and the short-term time horizons of financial institutions means that financial market actors do not incorporate long-term type risks into their financial practices and thus miss the opportunity to manage and mitigate the risks today. Furthermore, there is a lack of sophisticated risk management tools addressing these risks.
In response, this research program will address these issues by developing tools and products that, first, reduce financial agents’ transaction costs to shift financial institutions’ focus to the long-term; and second, build financial agents’ capacity to effectively manage long-term risks.
The research program is centered around the idea of the triple M risk management – designed to create a way to approach resilience in the face of long-term risks.
- Measure the potential scale of these risks in terms of its impact on the economy and financial sector; as well as create models to understand the exposure of individual institutions and governments to this risk.
- Monitor the risks, for example by anticipating the probability and time horizon of the impacts when such risks materialize, or to monitor the exposure of assets within a portfolio, as well as monitoring the risk management and mitigation systems themselves.
- Mitigate the overall risk to society, economy, and financial markets with three steps: first to take preventive measures – prevent – so that the risk cannot materialize at all or the probability of its extent is minimized. Second, to reduce the consequences if the risks materialize and third to contain the risks to prevent it from becoming systemic.
The program is a key pillar of the original vision of 2° Investing. Specifically, it:
- Reduces the risk that climate change will be sidelined as new risks emerge (as seen in the pandemic);
- Ensures that risk management and supervisory frameworks have the institutional structure to mainstream climate risks as opposed to one-off, ad-hoc research exercises;
- Establishes mechanisms to translate long-term climate risks into current decision-making;
Note on the funders: Our research on this topic has received support from EIT Climate-KIC.