‘We are all in the gutter, but some of us are looking at the stars’, wrote the Irish playwright Oscar Wilde. The oft-quoted phrase came to mind when reading the influential reports by the Network for Greening the Financial System (NGFS) – a group of 91 central banks and supervisors that came with its second iteration of climate scenarios – and the Bank of England’s (BoE) second iteration of its Climate Biennial Exploratory Scenarios (CBES), both published this month. The updated NGFS publication sets out six possible climate scenarios ranging from early, orderly and ambitious action to a current policies scenario leading to 3˚C warming. The BoE is a member of NGFS, and the CBES scenarios are therefore broadly aligned with the NGFS scenarios and explore an Early Action, a Late Action and a No Additional Action scenario.
We welcome the emergence of global standard setting scenarios by central bankers. It is a clear signal to the global financial market that climate related risks and opportunities should be fully integrated into investment decision making.
Nevertheless, as independent climate scenario specialists Ortec Finance, together with our strategic partner Cambridge Econometrics, are concerned about the implied messaging of two of the NGFS scenarios: the Disorderly, Delayed Transition and the Hothouse World, Current Policies and, by extension, the CBES Late Action scenario.
NGFS and CBES scenarios are highly optimistic on the time left to transition and ‘orderliness’ of such transition.
Both the NGFS’s Disorderly, Delayed Transition scenario, as well as the BoE’s Late Action scenario assume the transition will only start in earnest after 2030. Yet they still succeed in limit global warming to below 2°C - placing the target transition date well out of the average investment horizon and political election cycle. This undermines a sense of urgency.
Also, the assumptions made are highly optimistic estimates of:
- the time left before the world needs to transition
- how fast the world can transition, and
- the ‘orderliness’ (e.g. volatility and sentiment shocks in financial markets) of such a transition.
We struggle to identify a historic precedent for this level of financial, economic and social change in such a compressed timeframe. Therefore, we would question the plausibility of this scenario.
In our view, by effectively rubberstamping a delayed transition, the NGFS and BoE may push the transition beyond a time horizon that is relevant for investors. It discourages the early and ambitious action required to stay below 2°C and understates the plausible near-term transition risks and opportunities.
NGFS fails to explore a prudent ‘hot house world’ scenario.
The counter-factual Hothouse World, Current Policies scenario, is equally troubling. In our view this scenario in which the world fails to transition does not represent a true ‘hot house world’ as it does not fully explore the increase in physical risks (e.g. extreme weather) and possible environmental tipping points that would lead to irreversible global warming well beyond 3°C.
By effectively not including a higher warming and, according to our research, even likely, hot house world scenario the central banking community risks understating the long-term impacts of failing to mitigate climate change. Given the high level of model risk inherent in physical climate modelling, surely fiduciary duty and best practice would lead us to err on the side of prudence.
Our view is that the latest NGFS update risks reinforcing complacency in the minds of key decision makers in both the public and the private sector. They might reasonably conclude: “we can wait until 2030 and still achieve a transition that successfully limits global warming to below 2°C… And if we fail – it’s not that bad. Ok let’s go back to focusing on the next quarter”. This is potentially dangerous in such an important year for advancing climate change policy. More so, it misses an opportunity to show much needed leadership in the “race to net zero”.
Recommendation: develop a deep understanding of scenario assumptions and tailor climate scenario analysis to enable climate-informed investment decision-making.
To mitigate the risk of falling into the ‘model says it’s ok’ trap, investors must build a deep understanding of assumptions and limitations of these standard-setting scenarios. In turn, they need to develop a range of plausible scenarios, recognizing that one-size-fits-all regulatory scenarios may not capture complex non-linear dynamics of the transition on the one hand, and physical risks associated with a warming world on the other hand.
Reasonably, the authors of the reports we mention here leave it up to the investors to read, analyze and interpret their reports and scenarios - with no clear direction for investment decisions or policies. Indeed, it is not in their remit to do so. But what are investors and policy designers to do?
As the American president Harry Truman once said that a pessimist is someone who makes difficulties of his opportunities and an optimist makes opportunities of his difficulties. Equally, Oscar Wilde would no doubt point out that everyone’s “stargazing gutter” is different. Without being overly optimistic Ortec Finance offers, together with its strategic partner Cambridge Econometrics, state-of-the-art customizable solutions for climate resilient investment decision-making.
One of our key strengths is to help our clients translate the economic impacts portrayed in climate scenarios, such as those published by the NGFS and CBES, to financial impacts relevant to their particular context. Furthermore, global investors may wish to explore less optimistic climate scenario narratives and assumptions, and crucially to expand the scope of these reference scenarios. We help our clients go beyond the current regional and sectoral scope of the NGFS/CBES. All this is key for making climate scenario analysis decision-relevant for investors.