This post is the seventh in a series to do with scenario analysis and the proposed SEC Climate-disclosure rule. The background to the series is explained in the first post: SEC Climate Rule: Scenario Analysis - Part 1.
Scenario Analysis
The first four posts in this series evaluated the scenario analysis sections of the proposed rule. The fifth post looked at the TCFD guidance to do with scenario analysis. In the posts we quote the wording of the rule using the page numbers in the SEC’s document (The Enhancement and Standardization of Climate-Related Disclosures for Investors).
In the sixth post - Two Roads - we saw that the SEC is encouraging the use of scenario analysis and consideration of “what might be”. In this post we explore the nature of the second road.
Imaginary Gardens with Real Toads in Them
The poem ‘Poetry’ by Marianne Moore contains the line,
Imaginary gardens with real toads in them
She was talking about a quality that fine literature often possesses, but her phrase captures the essence of scenario analysis. Those who are charged with developing scenario analyses need to visualize “imaginary gardens” — events and circumstances that have never existed, and that probably never will exist. However, the imaginary gardens are not science fiction — they could materialize. They are plausible. Inside each imaginary garden are one or more “real toads”. In other words, if the garden does become real, and if the visualized events do happen, then bad consequences will ensue.
Donald Rumsfeld, who was the U.S. Secretary of Defense under Gerald Ford, expressed the same line of thinking when he famously said,
. . . there are known knowns; . . . We also know there are known unknowns; . . . But there are also unknown unknowns — the ones we don't know we don't know.
Scenario analysis is not to with the “known knowns” — that is the first road. The gradual desertification of the American southwest is a “known known”. The event is understood, its impacts are easy to understand, and the timing can be predicted with reasonable accuracy.
Instead, the scenario analysis team (and the exercise has to be a team effort) tries to visualize the “known unknowns” and the “unknown unknowns”. With regard to climate change, the potential for the firing of the “clathrate gun” is a “known unknown”. We know that the subsea clathrates are present, and we know that a warming ocean will cause these clathrates to melt and emit methane. But we don’t know how much methane will be released. Nor do we know when the gun will be fired.
By their very nature it is impossible to describe the “unknown unknowns”. However, cataclysmic events such as world war belong in this category.
Black Swans
In his book The Black Swan: The Impact of the Highly Improbable Nassim Nicolas Taleb describes a ‘Black Swan’ as being an unpredictable event that has severe consequences. Black Swan events possess three key features:
They are a surprise and were not forecast by the risk models in use;
They have a major impact; and
After their occurrence, those involved rationalize what happened.
With regard to climate change, Black Swans are not quite the same as tipping points (page 51). They are closer to Rumsfeld’s “unknown unknowns”.
One example of a Black Swan could be a sudden and unexpected change in the sun’s activity. This has happened before, and it will happen again. Such changes could lead to either increased or decreased warming. The point is that few people consider the possibility, and even fewer are planning for it. They are Black Swans. Taleb concludes that, since we cannot predict Black Swans, we should focus on making systems more resilient, even at the expense of efficiency.
Earlier Posts in the Series
SEC Climate Rule: Scenario Analysis - Part 5
SEC Climate Rule: Scenario Analysis - Part 6