A Financial Mathematics Approach to Climate Change Risk

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It has recently been of substantial importance to study the impact of climate change on financial services industry. In his recent speech to Lloyds of London, Bank of England Governor, Mark Carney, said:***The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity. While there is still time to act, the window of opportunity is finite and closing.***The main objective of the proposed research program is to advance financial modelling in order to mitigate adverse effects of climate change and to reinforce the transition to lower-carbon economies.***Some of the core objectives of the program include the following. First, financial institutions play an integral role in guiding the broader economy's transition to a low-carbon future through the financing of abatement and adaptation projects, by reallocating investments towards renewable energies and clean technologies, and by continuing to encourage transparency through climate change-related financial disclosure. However, what actions/investments of financial institutions and in what proportions will mitigate climate change most efficiently? One of the core goals of this research program will be to use mathematical modelling with climate change risk to answer this question.***Second, there is substantial uncertainty in projections regarding the timing and extent of the future warming of the earth's climate, the level of damages, and society's ability to adapt to a warmer climate. Furthermore, this uncertainty goes beyond the traditional probabilistic uncertainty in the sense that some outcomes cannot be even conjectured. This research will develop the framework and specific approaches to incorporate ambiguity about climate change risk into financial modelling.***Third, financial institutions are susceptible to the climate change risk which, if not properly hedged, could lead to substantial losses as a consequence of the short term shifts in climate sentiment. The results of this research program will advance our knowledge of strategic asset allocation when green investments are included in the investment portfolios. ***Since the program is interdisciplinary in nature and represents a challenging intersection of Climate Science with Mathematical Modelling in Economics and Finance, its anticipated outcomes will be of particular importance to people working in financial mathematics, governments (e.g., policymakers), climate scientists, and financial services industry (banks, insurance companies, pension funds). Given Canada's commitment to the Paris Climate Agreement, this research program will be particularly important for building Canada's leadership and trajectory regarding its climate policy.