Climate risk is a rapidly moving space, where regulatory and business requirements are accelerating. To address these demands, insurers need coherent and transparent scenarios which allow them to quantify the financial impact from physical and transition risks.
The release of the phase 2 scenarios by the Network for Greening the Financial System (NGFS) in June 2021 represented a significant step forward in understanding the potential risks and uncertainties associated with different climate pathways, but there is still a long way to go.
To use a set of standard scenarios such as those produced by the NGFS to assess the impact on your asset and liability valuations, a series of additional modeling steps are required. Energy and climate variables must be converted into macroeconomic effects, and then into financial market variables such as interest rates, inflation, and asset class returns.
On climate, economic, and financial assessments, there are many significant unknowns. Basic facts such as the climate sensitivity (how much warming we will see for a doubling of greenhouse gases in the atmosphere), and economic sensitivity (how much damage we see given a level of warming) are both uncertain within a wide range. Technology costs and fiscal responses to climate shocks and carbon prices can further impact the overall results. While the NGFS scenarios may appear to have only a limited number of narratives, the total universe of possible outcomes is much larger when each of these assumptions is considered. Analyzing just one or two scenarios will not be enough to grasp the sensitivity to these underlying assumptions, and to assess the full range of plausible outcomes.
This paper covers the necessary steps in constructing climate scenarios.
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This article is published as part of the Moody's Climate Risk Insurers series.