Short-term climate scenarios can provide an input to help rewire the financial system
The Network for Greening the Financial System (NGFS) has released its first short-term climate scenarios. These are designed as a tool to evaluate the impact of climate change on the financial sector over a period that is in line with the policy and planning horizons for most businesses and governments.
Longer-term scenarios capture the full benefits of transition investments as well as the near-term risks associated with transition and physical impacts. By their nature, the short-term scenarios put more emphasis on the sources of physical and transition risks than on the upside opportunities from investments made to avoid these risks.
Even with the focus on the sources of climate-related risks that could reduce global GDP by 3%, the scenarios were criticized as potentially understating the risk because of the simplifying assumptions used to produce the first round of scenarios. Four scenarios were used, covering an orderly transition (Highway to Paris), a delayed but aggressive transition (Sudden Wake-Up Call), current policies (Disasters and Policy Stagnation), and a blend of physical and transition risks (Diverging Realities).
The criticism focuses on the limited blend in models between those where physical risks predominate and those where transition risks are the strongest, since a realistic outlook will include both physical and transition risks. Despite the limitations of short-term climate scenarios in capturing the most likely outcome, they can be useful if users acknowledge the limitations and don’t allow their expectations of future climate risk to be anchored to either the most optimistic or pessimistic scenarios.
The usefulness of climate scenarios is to outline a baseline for considering the different ways that climate risks could propagate through the global economy and financial system. The unrealistic elements, including assumptions that only advanced economies follow transition pathways aligned with the Paris Agreement, or simplifying assumptions to model only one type of disaster (flood or drought) each year, should impact how additional assumptions are layered on top of the baseline model.
OIC economies are (at least in the short term) more likely to be impacted by global economic trends than they are able to directly influence them. If these short-term scenarios are used by financial institutions, they should be viewed as generally representing less severe scenarios. They will have increasingly adverse conditions modeled on top to address the potential impact of physical and transition risks affecting a single country, and the potential follow-on conditions that may produce a more severe adverse impact than the same developments may produce in non-OIC countries.
For example, the scenarios overall put the most severe global GDP drop as a result of the climate-related risks at 2.5% below the baseline in the ‘diverging realities’ scenario that combines physical and climate risk. At the same time, the physical impacts of climate-related risks are estimated to peak at 12.5% of GDP in Africa. Most OIC countries are at greater risk of the physical impacts of climate change, and a realistic short-term climate scenario should incorporate this risk if they seek to model realistic impacts of climate change to OIC markets.
However, as raised before in connection with the FSB’s climate financial stability assessments, these tools shouldn’t be used in a vacuum because they could create unintended consequences for OIC markets and other emerging & developing markets.
The dynamic of climate change as a source of economic and financial risk did not emerge naturally. It arose as a result of two hundred years of historical emissions, and the process of generating those emissions involved significantly unequal sharing of the benefits. For the process of addressing the impacts of climate change, the costs should be similarly skewed towards developed countries to produce an equitable outcome for humanity.
The inequitable nature of climate change is also compressed into the short-term scenario. Scenario analysis should take into consideration realistic assumptions about the transmission of losses, but the impact on the financial sector should be more equitable than has been experienced historically. Pushing the realisation of climate-related transition and physical risks onto financial institutions in OIC markets could amplify the imbalance built into the global financial architecture that inhibits flows of climate, transition and adaptation finance.
A recent report from the Cambridge Institute for Sustainability Leadership provides recommendations for ‘rewiring finance’, including a focus on “addressing risk–return perceptions [for investments in EMDEs] that hamper the feasibility of investments in these regions, and creating demand signals for projects that support the transition away from fossil fuels.”
The problem being highlighted is the higher risk (often measured by credit ratings) attached to many OIC markets and other EMDEs, which influences the willingness to invest and the return expectations of investors and financial institutions. If climate-related scenario analysis is applied in a way that further constrains investment flows, then the bad-case scenarios lead to worse-case outcomes, because the necessary mitigation, transition and adaptation investments won’t be made.
If short-term scenario analysis is instead viewed as a way to prioritise projects based on their ability to mitigate climate change, support the transition or invest in adaptation, then it may be able to play a more constructive role. The efforts to ‘rewire finance’ will still be necessary to reduce barriers to the flow of finance to OIC markets and others that are EMDEs, and efforts to improve the realism of outcomes covered by short-term climate scenarios will be more fruitful in directing capital where it can be most effective.
