Prolegomenon for Managing Climate Risk

We put climate risks in the perspective of model risk using a model in the wide sense. Climate risks are systemic risks and may be clustered according to so-called volatilities, uncertainties, complexities and ambiguities (VUCA) criteria. The dominating VUCA component of climate risk is uncertainty. As capital-based risk measures are not appropriate when facing deep uncertainties (unknown unknowns), precautionary and resilient principles should be applied in order to manage and mitigate climate risks. Within the precommitment approach (PCA) subjective probabilities allow to discriminate between tolerable risks and acceptable ones. Typically, solvency capital ratios are determined for acceptable risks (known unknowns). The amount of determined solvency capital and estimations of model risk (for a model in the wide sense) 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 macro prudential supervision