The latest release of NGFS climate scenarios – Key highlights for institutional investors

Climate scenarios are a useful tool for financial institutions to understand the potential financial and economic outcomes associated with climate change. By modeling 'what-if' futures, these scenarios simulate the impacts on economies, sectors, and asset classes worldwide under a range of different conditions.

Currently, financial institutions have access to three broad categories of climate scenarios: publicly available scenarios, alternative scenarios (such as the Ortec Finance Climate Scenarios), and bespoke scenarios¹. Of the first category, the publicly available and freely accessible scenarios, developed by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) entered their fourth annual iteration last year since their initial release in 2020. This version introduces several updates and changes to their approach to assessing climate-related transition, physical and market risks compared to the 3^rd edition.

Increased climate transition risk impacts, but still comparably limited

The NGFS 'Net Zero 2050' scenario reflects stronger transition impacts, recognizing that a higher shadow carbon price and increased investment in low-carbon technologies are needed to reduce carbon emissions and limit global temperature rise to 1.5°C by 2100. The addition of the 'Fragmented World' scenario provides financial institutions with the opportunity to simulate outcomes involving both higher transition and physical risks compared to Phase III. Overall, the materiality of the transition impacts is still considered relatively mild across all seven scenarios. For example, in the Fragmented World scenario, countries with net-zero targets still achieve 80% of their targets, while countries without net-zero targets reduce their emissions in line with current policies. Close to 90% of global emissions are from countries with net-zero targets or those considering them, including China, the EU, the USA, and India.

Key takeaway: The continued shift towards increasing transition impacts is a positive step in recognizing the significance of transition risks. The introduction of a scenario under 'Too Little, Too Late', broadens the range of outcomes and adds substantial value for risk management purposes. However, the overall tendency to underestimate transition risks may lead to overly optimistic conclusions about the subsequent impacts, particularly if the worst-case scenario is a reversal of current policies, limiting the ability of climate scenarios to fully highlight the true materiality of climate change’s effect on economies and financial markets.

Certain real-world climate transition risks and effects remain omitted

The latest updates see NGFS exploring further additional potential outcomes via a new 'Low Demand' scenario, which assesses an unexplored transition driven by an overall reduction in energy consumption due to stronger societal behavioral changes. Such a scenario may include individual changes like reduced meat consumption as well as commercial scale shifts in preferred local sourcing to reduce transportation in the supply chain and increased energy efficiency in production. However, transition impacts across all scenarios remain largely determined by the shadow carbon price and do not account for the effects of targeted transition policies, like the US Inflation Reduction Act, which has successfully attracted inbound investment through its low-carbon stimulus package. Furthermore, the NGFS scenarios do not anticipate potential new capital created to stimulate and grow emerging technologies in response to an accelerated drive towards a low-carbon economy. For example, the reaction during COVID-19, where Europe generated $2 trillion worth of stimulus to boost research, innovation, and digital transformation to override the pandemic’s negative economic impacts.

Key takeaway: The coverage of a societal-driven transition risk provides new insights for financial institutions. However, primarily relying on a single representative of transition impacts without considering obstacles, new capital creation, and suboptimal behaviors arising throughout a low-carbon transition may lead to a less realistic assessment of overall outcomes and impacts.

Enhanced coverage of climate physical risks but limited incorporation of acute (extreme weather) physical risks

NGFS’ latest update has expanded extreme weather perils to include droughts and heatwaves, in addition to cyclones and floods, for estimating the GDP impact attributable to extreme weather. However, it takes a different approach to modeling the impact of each event, making the results difficult to compare. Droughts and heatwaves affect the flow of agricultural supply and labor productivity, while floods and tropical cyclones damage the stock of capital. The inclusion of more granular acute physical risks data from 56 countries, instead of a single global dataset, provides more meaningful results. While for countries with large geographical areas, the inability to capture differences between cities may still distort the overall assessment of GDP impacts.

Acute physical risks, driven by extreme weather and its impacts, are explicitly included in only three of the seven scenarios and are kept separate from other interdependent climate risks such as transition and chronic physical risks. Though it is noted the impacts can be applied to similar scenarios, it would not capture nuances of each emission and temperature pathway. Also, key climate risk is only accounted for in GDP impacts and does not enable financial institutions to understand more specific impacts within financial markets, such as equity returns.

Climate tipping points, an important consideration recently highlighted by the Institute and Faculty of Actuaries (IFoA), such as the collapse of the Greenland and West Antarctic ice sheets that could lead to a rapid rise in global temperatures, are currently excluded from the assessment. This limitation restricts financial institutions' ability to consider the potential subsequent impacts.

Key takeaway: The additional extreme weather perils and increased granularity, in the face of rising extreme weather events, enhances the overall coverage and assessment of physical risks. However, the ongoing exclusion of acute physical risks in certain scenarios and omission of climate tipping points may result in an overall underestimation of physical risks. The lack of integration of acute physical risks with other climate risks restricts their inclusion in the assessment of asset classes, thereby reducing the overall accuracy of financial market impacts across all scenarios.

Certain climate-related market reactions are unclearly defined

While the scenario narratives cover a range of macro-financial risks, including the effects on exchange rates, interest rates, inflation rates and equity index, their limited detail across asset classes prevents a clear understanding of the various potential market responses under different futures. Consequently, this lack of detail does not facilitate an understanding of whether and to what extent the size and permeance of market responses have been factored in. Potential responses include abrupt repricing events driven by extreme weather, sentiment shocks due to asset performance and revaluations, and stranded assets triggered by a rapid market sell-off in carbon-intensive assets following incoming low-carbon policies. These responses warrant considerable attention, as they may have a material and widespread contagion effect, including liquidity challenges, exacerbated market uncertainties, and pricing fluctuations.

It is vital to include and describe the underlying assumptions of these market responses, as they are key market risk drivers. These details and subsequent feedback effects will provide financial institutions with clarity on how pricing-in occurs over the course of each scenario and will enable them to identify the proportion that should be interpreted as pricing-in shocks.

Key takeaway: The elusive nature and limited transparency of financial market risks within the scenario narratives create challenges for investors seeking to understand how each scenario has incorporated market responses to physical and transition risks, and to quantify pricing-in shocks on asset classes.

Conclusion: Enhanced insights and industry-wide benefits in assessing climate risks

Top-down climate scenario analysis, as a relatively new field that significantly deviates from traditional risk analysis due to the uncertainty of climate change, requires continuous innovation and a commitment to ongoing improvements. The latest update of NGFS climate scenarios provides the investment community with a pragmatic and accessible option for understanding how their investment portfolios may respond to future scenarios arising from the effects of climate change. This supports peer benchmarking, disclosure, and reporting objectives, contributing to upholding overall worldwide financial stability. However, financial institutions undertaking stress-testing exercises and informing their strategic asset allocation decisions should remain cautious and aware of certain underlying limitations, particularly regarding the underestimation of transition and physical risks and the omission of pricing-in shocks and key financial market risks. To address these specific aspects of the investment process, financial institutions should consider other available climate scenarios that comprehensively cover the diverse and interconnected drivers of physical, transition, and market risks, along with their impacts on financial markets. Climate scenarios that adequately encompass all these climate risks will facilitate better decision-making and more informed strategies.

Want to learn more?

Our Climate & ESG Solutions Team is available to provide further detail on the Phase IV release of NGFS climate scenarios and how they and other climate scenarios can support a financial institution’s current requirements to address climate change in their investment decision-making.