Maybe climate scenarios are 'malarkey'?

This article has been made free-to-view. Like what you read? Then consider buying us a coffee here👇

In diplomacy, “double signaling” is the art of sending a message that’s intended to be interpreted differently by multiple audiences.  Central bankers are avid practitioners, since they are required to communicate what they do and why they do it to myriad stakeholders, from frazzled politicians to savvy hedge fund traders.

I couldn’t help but imagine myself the target of such “double signaling” from central banks this week. Two innocuous publications from the Bank of England (BoE) and Basel Committee on Banking Supervision (BCBS) seemed to be conveying an urgent message for those with ears to hear it:  our approach to climate scenario analysis is all wrong.

To be clear, there’s no indication – none at all – that the documents have any subtext to them whatsoever.  The BoE’s is a tightly written guide for financial institutions on how to use scenario analysis to quantify climate change risks.  The BCBS’ contribution, meanwhile, is a discussion paper on “the role of climate scenario analysis in strengthening the management and supervision of climate-related financial risks.”  Harmless stuff, right?

Sure, but grab your tinfoil hat regardless and come for a wander with me.

Let’s start with the BoE article.  The authors’ main contention is that common climate scenarios used for financial risk analysis – those crafted by the Network for Greening the Financial System (NGFS), International Energy Agency, Intergovernmental Panel on Climate Change, and Principles for Responsible Investment – are of limited use, to put it mildly: “[M]acro-climate scenarios ‘off the shelf’ provide a starting point for analysis but generally do not provide the level of detail end users need to undertake asset-level financial risk analysis.” (My emphasis). 

Using the NGFS scenario suite as an example, the authors highlight a number of shortcomings: their failure to capture certain chronic and acute physical risks, the calibration of the “damage functions” that define the relationship between temperature rise and GDP, and the absence of “tipping points” which may amplify and accelerate the effects of climate change in unexpected (and perhaps unmodellable) ways.  Tony and I have plenty of thoughts on all of these – for one, we’re not sure the consequences of climate tipping points will be financially relevant over the short-term business horizon – but that’s for another day. 

What’s of immediate interest is that BoE staff, who implicitly endorse the NGFS scenario suite given that the Bank is a network member, are basically saying they’re not very useful to financial institutions as they stand. 

The article goes on to explain various ways in which these scenarios can be “extended” to produce decision-useful outputs.  The list isn’t short.  The authors say financial institutions may want to acquire spatially granular climate risk data and projections to account for how climate impacts will vary from region to region.  They say “related variables” beyond the basic GDP projections produced under the scenarios could be useful – like countries’ debt to GDP ratios.  For individual company analysis, “toolkits to apportion sectoral impacts to the asset-level” may come in handy.  And so on.

The impression left is of a world where banks and supervisors have been handed down climate scenarios, and accompanying approaches to climate risk analysis, that need a variety of add-ons to be relevant.  This is good news for climate tech companies, which can provide thick layers of innovation on top of these macro scenarios that cater to institutions’ need for asset-level data.  But it’s arguably bad news for the central banks and regulators that have subjected the industry to round upon round of scenario analysis that may not have told us all that much at all.

The BCBS paper is also downbeat about the field. Discussing the limitations of climate scenario analyses (CSA) observed to date, the paper says: “[W]hile transmission channels of climate-related financial risks are increasingly understood, many have not been entirely captured in CSA yet. This poses challenges to the construction of scenarios combining macro-financial shocks and climate-related shocks.” 

The Committee paper also gripes about “gaps in the quality of observed data” used in CSAs, and – similar to the BoE paper – the dearth of “relevant variables.”  Together, these shortcomings limit CSAs’ capacity to measure climate-related financial impacts.  Once again “extending” scenarios is posited as a way forward: “Scenarios and exposure data for CSA may require greater granularity to appropriately evaluate changes in economic relationships. For scenario analyses that focus on direct effects of climate risk drivers, granular sectoral/geographical drivers are expected to provide keener insights than aggregated-level risk drivers,” the paper reads.

Neither the BCBS nor BoE papers wallow in the current shortcomings of climate scenario analysis.  Indeed, the former lists a series of “usage-specific considerations” – recommendations by any other name – and poses a number of questions to readers in the hope that the feedback could help make CSAs more effective as risk management tools.

But I can’t help but find it shocking that we’re at this juncture.  It’s been almost four years since the release of the first suite of NGFS scenarios.  Central banks from the UK to Singapore have conducted climate scenario analyses in an effort to understand climate risks, not to mention dozens of commercial lenders.  The outputs of these exercises have often suggested banks are largely robust to climate risks, results that may in turn have downgraded the urgency of climate-related supervisory programs across the industry.  And now we have the same supervisors who pushed for these analyses in the first place saying that the scenarios used aren’t up to scratch? 

I’ve said before, in opposition to Tony, that climate scenarios aren’t ‘malarkey’.  In other words, I believe they can be useful for risk management purposes.  However, I did caveat that “mainstream” climate scenario analyses conducted by central banks and institutions “use the wrong tools and focus on the wrong time horizons.”

Much of what the BoE and BCBS papers say reinforces this view.  In fact they sound ready to admit that new, more effective approaches are needed.  

If so, there’s an awkward conclusion to be drawn: the climate scenarios used to date were malarkey all along.