By Laura Canevari
The Network for Greening the Financial System (NGFS) has released a set of high level and harmonised Reference Scenarios in June, 2020. Central banks and supervisors have the responsibility to prepare for the potential impacts from climate change. Yet, there are great uncertainties regarding what climate change impacts may look like in the future, as the way that climate risks will take shape is dependent on the carbon-intensity development pathways that countries decide to take. The use and application of foresight tools such as scenario analysis allows organisations to test the robustness of their strategies against a number of plausible and coherent future storylines.
The use of scenario analysis as a tool for robust decision-making is already being promoted in the private sector through the efforts of the Task force on Climate-related Financial Disclosures (TCFD). Organisations can face many challenges when trying to develop and apply scenario analysis for financial planning. In particular, it is difficult for non-experts to penetrate the technical parameters and assumptions behind climate change models, ultimately to decide which climate and emissions scenarios to use in order to explore a good range of plausible futures. Set out in the publication, ‘NGFS climate scenarios for central banks and supervisors’, the Reference Scenarios are therefore well-placed to help organisations (central banks, supervisors, other financial institutions and corporates) explore the impacts of transition and physical climate risks to the economy and the financial system in a consistent and transparent way.
Apart from setting out Reference Scenarios, the new NGFS climate scenarios guide offers a four-step process for scenario analysis, which are briefly described in Figure 1. (Source: NGFS, 2020)
In Step 1, central banks and supervisors should first consider how the exercise will relate to their objectives and define whether the scenarios are going to be used to:
- Assess specific risks to financial firms,
- Assess financial system-wide risks
- Assess macroeconomic impacts
- Assess risks to a central bank’s own balance sheet
As part of this first step, central banks and supervisors need to define what are the most material risks to the institution’s objectives, which can help in the identification of physical and transition risks that are likely to have the greatest impact. At this stage, it is also important that central banks and supervisors consider how different stakeholders (e.g. financial institutions, financial standard setters, governments) will be involved in the scenario analysis.
In Step 2, central banks and regulators are suggested to make a number of informed choices on the climate scenarios assumptions they will use for scenario design (e.g. Greenhouse Gas (GHG) concentration and socio-economic pathways as well as policy, technology and market trends). At this stage, central banks and supervisors should consider the types of climate risks that they want to explore and the NGFS strongly encourages the use of multiple scenarios in order to explore a range of futures in order to unveil the broad spectrum of transition and physical risks that could emerge under different economic development pathways. As noted in the guidance report, “The number of scenarios that central banks and supervisors choose to analyse will depend on the objective of the exercise, the materiality of the macro-financial risks, and resources available.” (p. 14). This also applies to the choice of scenario granularity and choice of time horizons.
For the NGFS Reference scenarios, multiple models were used to capture a range of uncertainty in the results, although they were all build against the assumptions of the same socio-economic pathways (namely the SSP2 “middle of the road” pathway). But each varies according to how policy and technology are assumed to evolve. A number of scenarios are thus developed according to these assumptions, namely:
- Three orderly transition scenarios: One which is representative and assume immediate action is taken to reduce emissions in alignment with the Paris Agreement and that all CDR technologies needed to reach net zero carbon are available; and two additional ones which are even more ambitious;
- Three disorderly transition scenarios, which assume delayed policy action and limited access to CDR technologies but differ in the extent of dependence on Carbon Dioxide Removal (CDR )technologies;
- Two “Hot
house world” scenarios [i.e. the current
- One scenario which assumes only current policies are implemented and the goals of the Paris Agreement are not met, leading to substantial physical risks over time and another that accounts for all; and
- One scenario which incorporates all pledges from Paris (even if not yet implemented) and leads to substantial, yet less, physical impacts.
In Step 3, central banks and supervisors will use the scenarios to assess economic and financial impacts. There are many challenges for doing this. For example:
- It is difficult to anticipate and model the extent of macro-financial impacts caused by physical impacts due to tipping points in the Earth system that we are just starting to understand (e.g. loss of ice sheet, permafrost and forest loss).
- Current economic models are ill-suited to study climate risks so central banks may need to deploy a combination of approach to tackle limitations of existing models.
- The channels through which economic impacts translate to financial impacts are complex
- Additional variables may be needed due to the limited number of macro-financial outputs available from climate models underpinning the scenarios.
- There is limited data and research to support scenario analysis
To refine the scenarios, the NGFS also encourages central banks and regulators to revise scenario assumptions, address more comprehensively systemic risks, further elaborate on transmission channels, and perform a second round of the exercise. This recommendation is already being taken forward, for example, by the Bank of England (BoE) in its 2021 Biennial Exploratory Scenario (BES) exercise.
Step 4, the final step set out in the guidance, helps central banks and supervisors define their communication strategy of scenario analysis results. It includes guidance on the type of information that should be disclosed, the intended audiences and methods to communicate the results.
As noted by Frank Elderson (Chair of NGFS) and Sarah Breeden (BoE and Chair of Macrofinancial workstream) in the Foreword of the report, “Challenges and shortcomings remain. Indeed, we are close to the start of this intellectual journey not at its end.” The effort to harmonise scenario approaches and provide relevant guidance to central banks and regulators achieved in this document, however, is commendable and offers a good foundation for future developments in climate scenario analysis. Not only are the Reference Scenarios and guidance relevant for central banks and regulators, they can in fact be instrumental for financial firms and corporates that want to explore their exposure to these emerging risks.