Scenario analysis may ‘understate’ climate risks, warn FSB and NGFS

A new report has warned that current climate scenario analysis exercises “may understate” climate exposure and vulnerabilities. Prepared by the Financial Stability Board (FSB) and the Network for Greening the Financial System (NGFS) for G20 leaders ahead of the Bali summit, the analysis finds that many exercises do not capture second-round effects, potential non-linearities and other large sources of climate risk.

NGFS scenarios play a “critical role” in providing reference climate macrofinancial examples and supporting scenario analysis by financial regulators and supervisors, the report says. Scenarios are also raising awareness and are feeding into policy discussions.

However, large variations in scope and objectives make it difficult to allow a straightforward comparison of results, while climate-related tail risks and spillovers are difficult to incorporate. As a result, “measures of exposure and vulnerability are likely understated”.

“Climate scenario analyses exercises are at an early stage, given the complexities of scenario analysis and modelling climate risks as well as the lack of necessary data,” the analysis concludes. “For now, the findings of the exercises have not translated into micro or macroprudential policies.”

The NGFS will continue improving its climate scenarios, it says, adding more granular data at the sectoral and geographical levels, and more data on physical risks. It will also work toward providing shorter term scenarios, including some focusing on “more adverse developments”.

“This joint report underscores the importance of work to enhance the understanding of the financial system vulnerabilities from climate-related risks,” said Klaas Knot, FSB chair and president of De Nederlandsche Bank in a statement announcing the report’s release. “A key priority going forward will be to enhance the understanding of how first-round and second-round effects under different scenarios could give rise to financial stability concerns.”

Climate risk also featured heavily in the FSB’s 2021 annual report, also published this week. Calling for accelerated progress in the implementation of climate-related disclosures, it welcomed the International Sustainability Standards Board’s work to develop a global sustainability reporting standard. The report also reviewed the FSB’s roadmap for addressing climate-related financial risks, delivered to the G20 last year.

“Exposure to the physical and transition risks posed by climate change is a pressing emerging vulnerability,” the FSB said in its annual report, saying that climate events could lead to sharp changes in asset prices.  “There is a danger of a climate-driven ‘Minsky moment’ if investors perceive that policy or technological change may come more quickly than previously anticipated,” it warned. “This could bring about a disorderly adjustment in asset prices which could spill over to other markets or jurisdictions.”