Here we go again: the misuse of models and the looming climate crisis

Source abstract

Abstract Climate-related financial risks are characterized by path dependence, non-linear feedbacks, regime shifts and the possibility of endogenous instability. Yet most models used in climate scenario analysis and financial stress testing utilize an equilibrium paradigm that imposes precisely the stability properties that such risks call into question. We revisit the Sonnenschein–Mantel–Debreu (SMD) theorems to clarify the mathematical foundations of this problem. We then examine the use of integrated assessment models (IAMs) in the analysis of climate-related financial risk, with particular attention to the scenario frameworks promoted by the Network for Greening the Financial System (NGFS), and argue that equilibrium-based models are poorly suited to describe mechanisms involving leverage, credit contraction, asset repricing, physical constraints and self-reinforcing financial feedbacks. Finally, we review the alternative modelling paradigms of system dynamics, agent-based modelling and stock-flow consistent macroeconomics through the MEDEAS, DSK and GEMMES frameworks, respectively. These models illustrate how explicitly modelling adjustment processes, biophysical constraints, heterogeneity, balance sheets and private debt can generate instability, regime shifts and climate-financial outcomes that are ruled out or strongly constrained in conventional equilibrium IAMs. The central methodological implication is that, in climate finance, stability should be treated as an outcome to be investigated rather than an assumption imposed at the outset.