An uncertainty-based risk management framework for climate change risk

Abstract

Climate risks are systemic risks and may be clustered according to so-called volatilities, uncertainties, complexities, and ambiguities (VUCA) criteria. We analyze climate risk in the VUCA concept and provide a framework that allows to interpret systemic risks as model risk. As climate risks are characterized by deep uncertainties (unknown unknowns), we argue that precautionary and resilient principles should be applied instead of capital-based risk measures (reasonable for known unknows). A prominent example of the proposed principles is the precommitment approach (PCA). Within the PCA, subjective probabilities allow to discriminate between tolerable risks and acceptable ones. The amount of determined solvency capital for acceptable risks and estimations of model risk may be aggregated by means of a multiplier approach. This framework is in line with the three-pillar approach of Solvency II, especially with the recovery and resolution plan. Furthermore, it fits smoothly to a hybrid approach of micro- and macroprudential supervision.