Research Methodology
The cost of inaction: Recognising the value at risk from climate change is a report by The Economist Intelligence Unit (The EIU). This research depicts the scope of assets at risk from climate change from the present to 2100. This innovative achievement draws on a modelling endeavour that combines The EIU’s long-term forecasts with a nuanced, integrated assessment model provided by Vivid Economics. The full methodology can be found in the appendix to this report which can be downloaded here for free. This white paper further discusses the possible consequences of climate change as well as how both investors and governments are measuring and responding to climate-related risks. The findings of this paper are based on detailed modelling, extensive desk research and interviews with a range of experts, conducted by The Economist Intelligence Unit.
To estimate the effect of climate change to 2100 on the changing stock of manageable financial assets, The Economist Intelligence Unit (The EIU) and Vivid Economics have used a leading, peer-reviewed forecasting model of the impact of climate change on the economy, the DICE (Dynamic Integrated Climate-Economy) model. DICE is one of a small number of integrated assessment models (IAMs) that have been built to estimate the economic cost of future climate change. These models link economic growth, greenhouse gas emissions, climate change and the damages from climate change back on the economy, and they do so in an integrated, consistent framework. They are typically built by adding a model of climate change to an existing framework for modelling the macroeconomy, with carbon emissions and climate damages providing the primary links between the two. DICE is the most popular of these models, having been used and cited in thousands of academic studies over nearly three decades.
The traditional purpose of IAMs has been to estimate the size of the climate change externality—the social cost of greenhouse gas emissions—in order to inform policymakers in setting emission targets or carbon prices. A famous example of such an exercise is the Stern Review, which estimated the present value of the future social costs of climate change to be equivalent to 5-20% of global GDP. The US Environmental Protection Agency has also recently used a suite of IAMs, including DICE, to determine the social costs of carbon for federal regulatory impact assessments. Since the value of financial assets is intrinsically linked to the performance of the
economy, the innovation of this study is to use the DICE model to estimate the impact of climate change on financial assets instead.
This modelling recognises that, since the present value of a portfolio of equities should be the discounted cash flow of future dividends, then in the long run—ie, over the course of a century—dividends in a diversified portfolio should grow in line with GDP, as ultimately dividends are paid for from the output of the economy. In well-functioning financial markets the same relationship with GDP growth should hold for cash flows from other kinds of assets, such as bonds. This relationship may not be observed over a relatively long time period, even decades, owing to business cycles; for example, corporate profits are currently at historical highs, while GDP growth is low. However, on average, to 2100, this relationship can be expected to hold up. The DICE model is then used to forecast the effect of climate change on GDP, and in turn on cash flows from assets. The results are for total global assets as DICE is a globally aggregated model that does not allow explicit disaggregation by asset class or by region.
