In our last post we agreed that climate change is one of the most significant challenges of our time. Understanding the potential risks and impacts of climate change is essential for ensuring a sustainable future. Scenario-based climate risk modeling is one tool that can help policymakers, businesses, and financial institutions understand how different climate scenarios could affect their operations and investments.
One of the leading organizations in the field of climate risk modeling is the Network for Greening the Financial System (NGFS). It’s a global network of central banks and financial supervisors committed to promoting sustainable finance and addressing climate-related risks. The NGFS has developed a set of climate scenarios to help financial institutions understand the potential risks and impacts.
NGFS Climate Scenarios
The NGFS has developed three climate scenarios:
- A disorderly transition, a baseline scenario, and a strong climate action scenario. The disorderly transition scenario assumes that countries will not take significant action to address climate change. This scenario leads to a sharp and disruptive transition to a low-carbon economy.
- The baseline scenario assumes that countries will take some action to address climate change. However, it will be insufficient to limit global warming to below 2°C.
- The strong climate action scenario assumes that countries will take ambitious action to address climate change. And this action will result in to a rapid and orderly transition to a low-carbon economy.
For financial institutions, understanding the potential impacts of these scenarios on their operations and investments is critical. A report by the NGFS estimates that physical risks associated with climate change could lead to a loss of $2.5 trillion in annual GDP by 2050. This will leave the financial services sector being particularly vulnerable (NGFS, 2020).
Scenario-based Climate Risk Modeling in Financial Services
One sector that is particularly vulnerable to climate risk is the financial services industry. Financial institutions are exposed to both physical and transition risks. Understanding the potential impacts of these risks is critical for managing their portfolios effectively.
Scenario-based climate risk modeling can help financial institutions understand how different climate scenarios could affect their portfolios. One actual implementation of scenario-based climate risk modeling is by the Bank of England. BoE has developed a framework to assess the impact of climate change on the UK banking sector.
Climate Biennial Exploratory Scenario
The framework, known as the Climate Biennial Exploratory Scenario (CBES), is designed to test the resilience of the UK banking sector to different climate scenarios.
The CBES scenario includes a range of physical and transition risks, such as a severe drought in the UK, a global shift to renewable energy, and a sudden and disorderly transition to a low-carbon economy. The Bank of England has used this scenario to assess the potential impact of climate change on the UK banking sector.
According to the Bank of England’s 2021 CBES report, under a scenario of a disorderly transition, the UK banking sector’s losses could be up to 25% of its Tier 1 capital. This scenario would involve a sudden and disorderly transition to a low-carbon economy, resulting in a sharp decline in the value of fossil fuel assets and significant disruption to the financial system.
Conclusion
Scenario-based climate risk modeling is one tool that can help policymakers, businesses, and financial institutions understand how different climate scenarios could affect their operations and investments. The NGFS provide a framework for financial institutions to model the potential impacts of climate change. By understanding and addressing climate risk, financial institutions can not only better manage their profitability. But also contribute to a sustainable future!
Check out the next post on Climate Risk: Enhanced disclosure & reporting – Ankur Garg