31st October 2023
“Climate Scenarios aren’t forecasts, but data-driven narratives that help companies think through different possible futures.” - Mark Carney*
The complexities of the global climate crisis and its impacts across multiple dimensions have given rise to unprecedented global challenges. Governments, corporations, investors and affected stakeholders are having to make crucial decisions, ranging from our present and future energy mix to how we will produce goods and services with very limited information on how our future will play out. Climate scenarios are a key tool to help navigate society towards a sustainable future amid a backdrop of tremendous uncertainty.
Climate scenario analysis provides an integrated approach to thinking about how the world could evolve, informing decision-makers in a structured and systematic way about possible future states and ultimately allowing them to better understand the interrelated impacts of climate change across societies, economies and the environment. Key benefits include a better understanding of the dynamics driving future outcomes, associated leverage points, increased transparency around the factors involved and a more thorough assessment of potential risks. Scenario analysis has long been used within strategic planning to add fresh and more holistic perspectives and improve resilience and climate scenarios are focused scenarios delivering relevant insights. They are recommended by the TCFD, the Task Force on Climate-related Financial Disclosures when making climate strategy disclosures.
When looking at climate scenarios and climate risks, it is helpful to make the distinction between physical risks and transition risks. Physical risks stem from the impacts of exposure to climate hazards such as extreme weather events. Transition risks are associated with our journey towards a low carbon economy, such as the costs arising from stranded oil assets. Institutions will look to incorporate both physical and transitions into their scenarios.
With transition risks, institutions will assess whether their strategies and portfolios of activities align with the implications of globally projected GHG emissions trajectories, for example the impacts of a carbon tax.
It is useful to differentiate between normative and exploratory climate scenarios. Normative scenarios take a future outcome as a starting point, for example net zero targets, and are constructed by working backwards. By contrast, exploratory scenarios, recommended by TCFD, establish different sets of starting conditions and see how they evolve.
Climate scenario analyses can vary depending on an institution’s unique goals: for example, climate scenario analysis for a company making decisions about its future operating model may contrast with the aim of a bank performing climate scenario analysis and climate stress-testing to model climate impacts on its lending portfolio, or of a regulator assessing in aggregate the relative stability of a financial system under climate scenarios.
Climate scenarios have a series of critical parameters and assumptions that act as key drivers and help define development pathways over the scenarios’ time-horizon. These are generally grouped into major categories including:
While customised climate scenarios are valuable inputs for institutions facing different sets of challenges, often as a starting point; standardised reference scenarios provide a strong basis for climate scenario analysis. Reference scenarios provide a set of pre-agreed estimates and trajectories around key factors including global greenhouse gas emissions and are supported by socio-economic narratives and assessments around climate impacts. The most popular and widely-used reference scenarios include the IPCC, the International Energy Agency (IEA) and the Network of Central Banks and Supervisors for Greening of the Financial System (NGFS).
IPCC current scenarios are essentially driven from the perspectives of how future atmospheric GHG concentrations will change – representative concentration pathways (RCPs) – as well as how changes in factors including population, economic growth, education, urbanisation and technology will affect future GHG emissions – shared socioeconomic pathways (SSPs). The IPCC, in its most recent sixth assessment report, said that “Global GHG emissions in 2030 implied by nationally determined contributions (NDCs) announced by October 2021 make it likely that warming will exceed 1.5°C during the 21st century and make it harder to limit warming below 2°C.” NDCs are the self-defined national climate pledges under the Paris Agreement.
In its World Energy Outlook 2022, the IEA came up with three main scenarios:
With these scenarios, it is also worth highlighting the difference in APS and STEPS or the implementation gap based on what countries have pledged to do and what they are actually doing, as well as the ambition gap, the difference between APS and NZE as it reflects that pledges collectively made are not ambitious enough to limit the global average temperature rise to 1.5°C.
NGFS scenarios, while critically supporting central banks, supervisors and financial market participants, also provide comprehensive decision-useful financial and economic analysis and inputs into climate scenarios for related stakeholders in an open-source platform. The NGFS provides a standardised set of transition risk, physical risk and macroeconomic variables together with the major assumptions they are based upon, which draw on existing IPCC-assessed climate mitigation and adaptation pathways. The design of NGFS’s climate scenarios looks to incorporate: atmospheric concentration of GHGs, socioeconomic context, technological evolution, climate policies, consumer preferences, and climate impacts.
NGFS’s six long-term scenarios are categorised as follows:
The NGFS has also published five short-term climate scenarios, covering a time horizon of three to five years with the aim of overcoming limitations in macroeconomic and financial risk analysis stemming from long-term climate-economy relationships captured in its long-term climate scenarios. These short-term climate scenarios are grouped as follows:
Transition and physical risk:
Given the complex nature of climate scenario analysis, varying assertions continue to be made on potential outcomes including the Inevitable Policy Forecast and Forecast Policy Scenario Analysis 2023 update, commissioned by the Principles for Responsible Investment, which has a high conviction forecast of temperatures peaking at 1.7-1.8°C by the 2040s, signalling that the Paris Agreement “well below 2°C goal” will be met.
It is important to be aware that fundamental questions are being asked about the robustness of climate scenario modelling. Assertions are being made that, with the approach of tipping points – natural thresholds which once crossed, trigger irreversible changes such as loss of the West Antarctic ice sheet – could cascade into future new states, which have not been captured in current climate scenario analyses.
Research has showcased a major divide between economically-driven climate scenarios and climate scientists’ expectations of future states. Economists have claimed in refereed economist papers, that 6°C of global warming will reduce global GDP by less than 10% as compared to without climate change impacts.
This is in stark contrast to climate scientists, who have claimed in refereed science papers, that 5°C of global warming imply damage that is “beyond catastrophic, including existential threats” while even 1 °C of warming, which has already been passed, could trigger dangerous climate tipping points. (Institute and Faculty of Actuaries – The Emperor’s New Climate Scenarios (2023) & Carbon Tracker - Loading the DICE against pension funds (2023).
With the increasingly alarming impacts of climate change comes the need to empower leaders to take proactive steps towards more sustainable and resilient outcomes. Climate scenarios can provide decision-makers with valuable perspectives and crucial insights, supporting stakeholders in best navigating uncertain future states to ultimately achieve the goal of a sustainable world for generations to come.
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