Governments must fix ‘faulty radar’ in economic climate models

Economic models used by governments, central banks and investors are increasingly understating physical climate risk because they rely on assumptions that break down as the world moves toward higher levels of warming, according to a new report from University of Exeter and Carbon Tracker.

The report Recalibrating Climate Risk – drawing on expert judgment from more than 60 climate scientists – finds that many economic models are failing to capture the extreme events, compounding shocks and rising uncertainty likely to dominate impacts in a hotter world. 

Jesse Abrams, lead author and Senior Impact Fellow at Green Futures Solutions, University of Exeter, said: “Our expert elicitation reveals a fundamental disconnect: climate scientists understand that beyond 2°C, we’re not dealing with manageable economic adjustments. The climate scientists we surveyed were unambiguous: current economic models systematically underestimate climate damages because they can’t capture what matters most – the cascading failures, threshold effects, and compounding shocks that define climate risk in a warmer world and could undermine the very foundations of economic growth. 

“For financial institutions and policymakers relying on these models, this isn’t a technical problem – it’s a fundamental misreading of the risks we face, which current models miss entirely because they assume the future will behave like the past, even as we push the climate system into uncharted territory.”

The flaws in economic modelling have drawn attention in recent years, with influential models criticised by UK actuaries and scientists for understating climate impacts that many scientists now anticipate. Following the recent withdrawal of the “Economic Commitment of Climate Change”, the report sets out to close that gap – by establishing early consensus on how to best improve those estimates and calling for closer collaboration between climate scientists and economists.

The result is an assessment that examines – in detail – how uncertainty is treated, how far GDP-based estimates remain meaningful, and what this means for financial regulators and investors as the world moves toward 2°C.

Key findings include:

• Climate damages are structural and compounding – not marginal. At higher levels of warming, climate impacts are increasingly likely to disrupt multiple sectors at once, as physical risks cascade across trade, finance, migration. These non-linear, structural impacts are likely to increasingly reshape entire economies and undermine the necessary conditions for economic growth. This undercuts against a core assumption in many economic models, which assume that economic growth continues indefinitely, merely at reduced rates.
• Extremes, not averages, define the future of climate damages. 
  • While economic modelling has traditionally linked damages to changes in global mean temperature, societies and markets experience climate change through local and regional extremes, such as heatwaves, floods and droughts, which drive the bulk of economic and financial disruption while often barely registering in global averages.
  • Similarly, experts find that gross domestic product (GDP) can mask full harms by failing to account for impacts on mortality and morbidity, inequality, ecosystem loss and social disruption – all factors that undermine societal, human and economic health. As these risks rise, continuing to rely on GDP-based assessments can give policymakers and financial institutions a false sense of resilience even as underlying vulnerability increases (e.g., recovery spending that spikes GDP after a climate-related disaster, masking welfare losses entirely).
• Uncertainty rises sharply with warming. With temperatures trending towards a 2°C future, experts stress that impacts become increasingly unpredictable, as tipping points and tail risks increase. Even as models continue to produce precise-looking point estimates, climate risks will likely undermine the assumptions of continuous growth fundamental to many economic models. Policymakers should be wary of climate scenarios extending beyond certain temperature levels and take a ‘broad spectrum’ approach to tail risks.

The report provides recommendations to financial regulators and central banks, to institutional investors and pension funds, and to financial advisors and scenario providers. 

• From a prudential perspective, the objective should not be to price climate risk with precision, but to ensure the financial system’s resilience against destabilising outcomes. This includes supervisory practices that place greater emphasis on extremes, compounding effects, tail risks, and systemic vulnerability.
• For long-horizon investors, the report challenges the assumption that climate risk can be adequately measured through conventional financial metrics and managed through portfolio diversification approaches, warning that portfolios may appear resilient under standard macroeconomic indicators while experiencing rising exposure to physical disruption, correlated shocks, and systemic vulnerabilities.
• For scenario providers and users, the report challenges the practice of presenting single “best-estimate” projections as a basis for policy planning, and warns that climate scenarios should support risk management under deep uncertainty, rather than optimisation around a single “best-estimate” trajectory.

The report also introduces new approaches to improve damage modelling – reflecting expert judgement that beyond certain warming levels, economic modelling can appear precise while no longer describing real-world outcomes – and outlines a clear research agenda. 

It also stresses that the appropriate response is not to wait for perfect models – but to recalibrate governance toward precaution, robustness and transparency.

Mark Campanale, Founder and CEO, Carbon Tracker Initiative, said: “The net result of flawed economic advice is widespread complacency amongst investors and policy makers, with many investors viewing climate scenario analysis as a tick-box disclosure exercise. Until the gap between scientists and economists’ expectations of future climate damages is closed and Government bodies act to ensure the integrity of advice upon which investment decisions are made, financial institutions will continue to chronically under-price climate risks – meaning that pension funds and taxpayers will remain dangerously exposed.”

Laurie Laybourn, Executive Director of Strategic Climate Risks Initiative and Board Member, Carbon Tracker Initiative, said: “As the UK government’s landmark security assessment of ecosystem collapse showed last week, we are currently living through a paradigm shift in the speed, scale, and severity of risks driven by the climate-nature crisis. Yet, beyond this report, there has not been a corresponding paradigm shift in how regulators and government as a whole assess these risks. Instead, they’re routinely underestimated if not missed entirely, meaning many regulations and government action are dangerously out of touch with reality. This threatens disaster when that reality catches up with us. So, it’s critical that policymakers change course, providing clear signals and guidance to markets that these risks should be priced accordingly, rather than downplayed.” 

Hetal Patel, Head of Sustainable Investment Research at Phoenix Group, said: “Phoenix supports the report’s call for a more robust and co-ordinated approach to climate‑risk modelling. Underestimating physical risk doesn’t just distort financial analysis and investment decisions, it underplays the real‑world consequences that will ultimately affect customer outcomes and society as a whole. As one of the UK’s largest asset owners, we urge policymakers to act decisively on the systemic risks identified in this research and to set clear expectations for financial sector users.”

Faith Ward, Chief Responsible Investment Officer, Brunel Pension Partnership, said: “The toolkit is broken! Climate change presents an immediate, systemic and material risk to the ecological, societal, and financial stability of every economy and country on the planet – with direct implications for pension providers and their beneficiaries. And yet, when translated through risk tools that are provided to us as investors, damages are estimated in fractions of a percent. The consequence is a failure to equip pension funds with a fully informed range of climate outcomes that can help them to address a fundamental systemic risk to the fund’s financial performance.”