We are kidding ourselves about the favoured climate-risk scenarios, says Mark Cliffe. A more realistic alternative incorporates the inconvenient truths they ignore: real life and human nature.
Imagine a world without storms, floods, wildfires, droughts or rising sea levels; where the economic damage caused by global warming grows gradually, and, for a few decades at least, modestly. There are no pandemics, wars, policy errors, recessions, stock market crashes; no unemployment or banks. Markets work, rising carbon prices shift the world away from fossil fuels and carbon removal takes off.
Welcome to Planet NGFS. This is the story, or fantasy, built into the integrated assessment models (IAMs) underpinning the climate risk scenarios of the Network for Greening the Financial System (NGFS), the Intergovernmental Panel on Climate Change and the International Energy Agency. This approach has become the de facto standard for finance and business.
While the NGFS admits the field is in its infancy, it has done little to confront the inconvenient truth that, in overlooking the risks and opportunities that will arise from climate change, its scenarios are not fit for purpose. They are not adequate for assessing the true long-term systemic risks posed by global warming, or the benefits of curbing it.
NGFS scenarios are even less useful in terms of the practical decisions that finance and business now need to make. Many have committed to helping the world plan to cut greenhouse gas emissions to net zero by 2050, and to get halfway there by 2030. This means we need cuts of more than 8% a year during the next seven years. Each organisation must answer simple questions such as how, when, where and how fast to act on climate change, and the answers may vary greatly depending on the organisation.
The Real World Climate Scenarios initiative, which I co-launched last year, is dedicated to developing more realistic and relevant climate scenarios to help fill the gaps in the current suite of official scenarios. Given governments’ and businesses’ diverse needs, these scenarios must cover a greater variety of time horizons, scales and scopes – thus requiring a broader range of methods and models.
Narratives eat modelling for breakfast
The challenge is recognising that building realistic climate scenarios is not, in the first instance, a modelling problem. In scenario planning, narratives eat modelling for breakfast: no amount of modelling will save you if you are not addressing the right questions. Before you ask “what kind of world might we be in?”, you need to ask “what are we trying to achieve?”.
The big question for asset owners, for example, is the outlook for asset prices – yet asset prices are absent from IAMs and NGFS scenarios, the output of which must be translated into the implications for asset prices using ‘expert judgment’. (Another inconvenient truth is that no one has produced a reliable model for forecasting asset prices.) NGFS scenarios are silent on the possibility of tail risks from asset price crashes that might follow sudden policy shifts or changes in investor expectations. These could crystallise stranded asset risk faster than the NGFS cares to consider.
Scenarios are not models or even forecasts, but descriptions of plausible futures that illuminate our understanding of the most impactful uncertainties. Narratives can make explicit assumptions about non-modellable drivers such as politics; imagine, for example, what may happen if the next US president is a climate-change sceptic.
That’s not to say models are unimportant. Modelling can clarify and quantify the narratives – but the narratives need to be relevant and actionable for their purpose. Narratives dictate scenarios’ relevant drivers, time horizons and scopes, which will dictate the methods and models used and the assumptions and data required.
It is also worth noting that models, which are simplifications of reality, are essentially stories that embody the modellers’ understanding of how the world worked in the past. Meanwhile, users’ narratives drive the assumptions that they put into the models. This is why different IAMs can produce different results, reflecting differing views on the co-evolution of factors such as technology choices, carbon pricing and removal. Models calibrated on past data can cope with stable systems but may be caught out by unstable systems. Like weather forecasters failing to predict storms, models can let you down when you most need them.
Planet NGFS or Planet VUCA?
There is growing awareness that standard climate narratives and models are missing crucial risks, tipping points and feedback loops, thereby understating the risks and opportunities. The disruptions flowing from Covid, the war in Ukraine, energy and supply chain dislocations, financial crises and extreme weather events have exposed the unreality of Planet NGFS. We need scenarios to embrace the fact that we are living on Planet VUCA: one characterised by volatility, uncertainty, complexity and ambiguity.
Standard climate narratives and models are missing crucial risks, tipping points and feedback loops, thereby understating the risks and opportunities
VUCA is not just short-term noise – it accelerates change in unpredictable ways. The complex interactions between the planet and our economic systems exhibit a path dependency that defies the equilibrium modelling of IAMs. As Stern, Stiglitz and Taylor put it in their paper The economics of immense risk, urgent action and radical change: towards new approaches to the economics of climate change: “IAMs have very limited value […] They fail to provide much in the way of useful guidance, either for the intensity of action, or for the policies that deliver the desired outcomes.”
More realistic scenarios will highlight that the short and long-term risks and opportunities of climate change are far greater than they have been portrayed. They should yield practical insights into the world as it is, rather than the smooth progression portrayed in IAMs. There will be volatility and disruption along the way, as we have experienced in recent years.
Real-world scenarios must embrace the complex impacts of geopolitical and geolocation shifts, wars, extreme weather, dislocation, migration, health factors, food and natural resources scarcity, asset toxicity and stranding, as well as the benefits of technological breakthroughs and societal tipping points.
Conventional scenarios, usually based on equilibrium modelling, also underplay the opportunities and benefits of the low-emissions, climate-resilient transition. They typically suggest that the transition will lead to higher inflation and lower growth, ignoring the possibility that technological progress will lower prices and boost growth. (See the article ‘Under the bonnet’ in The Actuary, March 2022.)
Accordingly, the current approach not only undercuts the case for net zero but also fails to provide decision-useful insights for the governments, finance and businesses committed to the urgent action required. We should be thankful that these commitments have held firm in the face of Planet NGFS’s complacency, bolstered by climate scientists’ growing alarm.
Now that the focus is on delivering net zero, transition planning is the priority. Governments, finance and businesses are working on detailed action plans, which means they need short-term scenarios as well as long-term ones. Many businesses have already voluntarily committed to tough interim decarbonisation targets for 2025 or 2030, and these are set to become tougher still, with a growing number of countries making them mandatory – including the UK.
Transition plans focus on how to reach net zero, so the NGFS’s long-term scenarios on alternative emissions and global warming outcomes are less relevant. Instead, we need scenarios that consider the different ways and speeds of reaching net zero – especially given that different countries and companies will pursue different pathways.
Moreover, global warming is baked in for the next decade. Even if net emissions fall rapidly during the next few years, the existing stock of emissions means further increases in the global average temperature are almost inevitable. And while there is considerable and growing uncertainty over how high temperatures will get from the late 2030s onwards, the likely range of outcomes for the 2020s is comparatively modest. In the language of scenario planning, global warming is a ‘pre-determined’.
The implication is that global warming and other ‘chronic’ physical risks are not key drivers for short-term climate scenarios. Instead, the drivers are extreme weather events and other acute physical risks, as well as transition risks that involve climate-related shifts in policy, technology, litigation, the economy and markets. These are often hard to quantify and model but scenario narratives can make explicit assumptions about them, including how they might interact. Planet NGFS relies on models that gloss over acute physical risks, which scientists fear are now rising rapidly, as well as many material transition risks.
The bottom line is that wise decision-making needs to use short-term climate scenarios that are based on relevant drivers and realistic narratives. In other words, they need to live on Planet VUCA, not Planet NGFS. What might these narratives look like?
Narratives to 2030
When looking to 2030 rather than the NGFS’s preferred 2050 horizon, climate risk scenarios entail quite different drivers and narratives. Global warming is a given and scenarios focus instead on uncertainties over human action and how it interacts with frequent extreme weather events. What matters most are transition drivers, which fall into two groups: (1) politics and policy (2) economics and markets.
Figure 2 shows a 2x2 matrix of a set of scenarios prepared for the Real World Climate Scenarios initiative. On the vertical axis, the first driver is the degree of policy activism. Aggressive action through carbon pricing mechanisms, fiscal support or government regulation will probably be the biggest factor in determining how quickly the world transitions. This will depend heavily on political will at national and international levels, throwing the spotlight on the electoral cycle in the US and other key democracies, as well as geopolitical relationships with China, Russia, and other major players. Given the sensitivities around such political questions, official bodies in the NGFS are understandably coy about addressing them.
On the horizontal axis, the second key driver is business and consumer dynamism. A dramatic shift in capital and spending will be needed to reach net zero, including the development and rollout of renewable energy and carbon removal technologies. This is unlikely to be the smooth process portrayed by IAMs: market booms and busts and policy interventions are likely to lead to volatility in prices and investment flows, and thus in attendant financial risks and returns.
The matrix scenarios involve four different combinations of high or low policy activism and high or low market dynamism. The most optimistic scenario, ‘Roaring 20s’, has both drivers working in harmony, resulting in rapid decarbonisation. In the most pessimistic scenario, ‘Meltdown’, a toxic political climate compounded by dysfunctional markets frustrates progress. In between are two scenarios in which either the markets (‘Carbon Bubble’) or policy (‘Green Phoenix’) stymie progress. In all scenarios, extreme weather events are woven into the narratives to accelerate or reverse the behavioural impetus driving the transition at local or global levels.
Saving yourself before the planet
The NGFS is planning to develop a set of short-term scenarios but has not confronted the issue of scale. Organisations and individual governments are not responsible for saving the planet, essential and laudable though that goal may be. Businesses’ first duty, often enshrined in law, is survival. Greening, or at least climate-proofing, your organisation is not necessarily the same as greening the planet.
The NGFS skirts this problem by implicitly pretending that its scenarios, designed to address global systemic risks, can be used to address idiosyncratic risks faced by individual institutions. However, individual companies and funds can insulate themselves from climate risks by offloading their carbon-intensive assets and investments, which may simply shift the risk to other parts of the system. This is the essence of climate change’s collective action problem, where your success depends on the action of others.
Here lies another inconvenient truth: for now, businesses’ fiduciary obligations are to focus on their own climate-related financial risks, taking the ‘outside in’ perspective on climate change. In accounting terms, this is the ‘single materiality’ approach to sustainability. However, net zero is inherently a broad societal impact goal involving an ‘inside out’ assessment of an organisation’s climate footprint, which is the second part of the ‘double materiality’ of sustainability accounting. Time will tell whether this part is enshrined in regulation.
Having committed to net zero, organisations must second guess whether others will deliver on that goal. This means that for their own decision-making, whether for transition planning, asset allocation or risk management, organisations cannot rely on NGFS-style systemic scenarios. They need bespoke scenarios that explicitly account for the behaviour of others, including competitors, suppliers, customers, other industries, governments and regulators.
The point here is that in a competitive environment, organisations are concerned with their performance in relative as well as absolute terms. Large, diversified pension funds with longer time horizons may be less concerned about short periods of underperformance but must still consider scenarios in which others behave differently.
There are dangers for individual organisations in greening their activities not just too slowly but also too quickly. In decarbonising too far ahead of the pack, a business may suffer from ‘premature virtue’ as carbon-intensive assets outperform. This point was illustrated recently by the favourable stock market reaction to BP paring back its relatively ambitious decarbonisation goals.
In contrast, if everyone else in the system delivers on their net-zero goals, you can afford to ‘free ride’ on their success. Bespoke scenarios therefore need to be constructed in a way that helps you answer the question ‘how fast do we need to move to net zero?’.
Consider Figure 3, which presents another 2x2 scenario matrix based on individual versus systemic success or failure to reach net zero. This yields four bespoke scenarios, in which success is ‘going green’ and failure is ‘staying red’. The ideal scenario is both you and the system going green, and the worst is both staying red. The other two scenarios, where you are out of line with the system, each present the risk of underperformance. The trick, as ever, is to be only one step ahead of the market.
A more realistic approach
The time has come for a reality check on the official scenarios that finance and business are using to assess climate change – notably those from the NGFS. Crucial risks, tipping points and feedback loops are missing from its narratives and models, meaning the risks and opportunities are understated. As a result, official scenarios are not fit for assessing the true long-term systemic risks of global warming, or the benefits of curbing it. They are still less useful for the practical decisions that finance and business need to make if they are to reach net-zero greenhouse gas emissions.
The Real World Climate Scenarios initiative aims to address these problems by developing more relevant scenarios that embrace the complex impacts of geopolitical shifts, wars, extreme weather, dislocation, migration, and asset toxicity and stranding, as well as the benefits of technological breakthroughs and societal tipping points. With many organisations having committed to net zero, the focus is now on transition planning, which calls for short-term and bespoke scenarios. Since global warming is baked in over the next decade, short-term scenarios require a switch in focus towards transition risks and extreme weather. And since the success of any organisation is contingent on the behaviour of others, bespoke scenarios need to acknowledge that organisations run risks not just in moving too slowly on decarbonisation, but also in moving too quickly.
Mark Cliffe visiting professor, London Institute of Banking & Finance