Recommendations Toward the Development of Scenarios for Assessing Nature-Related Economic and Financial Risks

January 22, 2024Published by Network for Greening the Financial System

The Network for Greening the Financial System (NGFS) has published technical recommendations, along with a non-technical summary, to guide central banks and supervisors in developing scenarios for nature-related economic and financial risks.

Central banks are increasingly acknowledging that widespread environmental degradation will result in diverse forms of financial risk with significant adverse impacts on the global economic and financial system, say the authors.

The technical document follows the NGFS beta conceptual framework on nature risk, which stressed that scenario development is one of the most important next steps for supervisors. Scenarios will enable central banks to move beyond isolated case studies towards a more dynamic and specific understanding of risks and vulnerabilities, according to the report.

The first section explores the challenges in developing consistent narratives for identifying physical and transition nature-related hazards.

Ecosystem processes are highly complex and to understand them multiple metrics, highly localised effects, and nonlinear dynamics must be tracked. Such nonlinearities include positive and negative feedback loops within and among ecosystems and natural processes, including climate.

Together these factors create a “local-global trade-off”. This refers to the tradeoff between capturing the locally specific environmental changes that are essential to nature-related patterns, while maintaining global macro-financial relevance and remaining simple enough to be actionable by financial stakeholders.

To overcome these challenges, the NGFS suggests two complementary methodologies for physical-risk-related hazard identification: the Environmental Sustainability Gap–Strong Environmental Sustainability index (ESGAP-SESi) and INCAF-Oxford.

The second section reviews current modelling of hazard impacts, with a focus on nature-economy and biophysical models.

Overall, they find that existing models do not fully account for most nature-related hazards and transmission channels linked to the macroeconomy. As such, they persistently underestimate the economic consequences of widespread nature loss.

The authors then examine alternative modelling approaches. They mostly focus on multi-regional input-output (MRIO) tables and models as a promising option. This approach is currently preferred as it can represent strongly adverse scenarios as well as how a specific nature-related hazard generates both direct and indirect shocks in multiple sectors.

While the MRIO approach can provide macro-financially relevant insights, it is not able to capture dynamic factors or provide information at the intra-sectoral level, both of which are important for forward-looking understanding of nature risks. This approach can be improved by utilising biophysical models to obtain maps of physical hazards, say the authors.

The paper concludes with options for central banks to move forward with nature-related scenarios. Overall, they stress that a comprehensive, methodologically-diversified and transparent approach to modelling the complex interplay between biophysical and economic systems is needed.

In the long-term, central banks can build more dynamic scenarios by focusing on refining nature-economy models.

This can be done by incorporating more nature-economy transmission channels, ecosystem services, policies, socioeconomic developments and elasticities of substitution.  Incorporating alternative macroeconomic assumptions, such as non-equilibrium approaches and environmental tipping points, is also an option.

This page was last updated January 23, 2024

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