Purposeful Scenario Analysis

A Framework to Guide Central Banks and Financial Supervisors in the Selection and Design of Climate Scenarios

June 28, 2023Published by LSE Grantham Institute

Climate scenario analysis is an “integral tool” for central banks to assess the impact of climate on financial and monetary stability. In this paper, researchers call for greater clarity on the purposes behind individual exercises and present a “typology of potential purposes” which can be used to optimise purpose-specific selection and design of scenarios.

Scenario analysis is suitable for addressing the inherent uncertainty of climate and nature related risks as it is forward looking, embraces uncertainty and nonlinearity, and allows for longer-term time horizons. The authors highlight the broad uptake of scenario analysis, citing research by the Financial Stability Board and Network for the Greening of the Financial System (NGFS) which counted 67 completed, ongoing or planned exercises across 36 jurisdictions.

The authors, Matthias Täger and Simon Dikau, explain that with clearly identified purposes central banks can assemble core elements to build specialised scenarios, identify trade-offs and gaps, and select scenarios appropriately.

In contrast, a lack of clearly defined purposes may result in widespread misuse of scenarios and systemic risk accumulation. Assumptions in the NGFS scenarios, such as perfect foresight and zero market friction, are relevant for top-down policy insight but may create market-wide blindspots if used extensively for bottom-up analysis of capital adequacy.

The authors present a typology which categorises central banks and financial institutions’ potential use of scenarios under two main subheadings: strategy and planning and policy implementation.

Firstly, scenarios are used in strategy and planning to support resilience, prioritisation and communication. Scenario analysis builds organisational resilience by establishing early warning systems and precautionary approaches which reduce reaction time to adverse circumstances. It aids prioritisation by identifying risk hotspots, transmission channels, and policy conflicts.

Secondly, central banks and financial institutions use scenarios in prudential and monetary policy implementation. For example, they can be used to test the resilience of systems including contagion and cascading risks. They are also used to assess the adequacy of capital requirements, the macroeconomic impact of climate and the effects of green monetary policies.

According to the authors, purpose-specific scenario design should be based around four dimensions:

  • narrative – the qualitative foundation determines the overall approach, including the relevant, timeframe, drivers and concepts
  • granularity – different uses require different degrees of sectoral, spatial and temporal granularity
  • model specificities – models should be tailored to the scenario purposes
  • uncertainty – purpose determines the extent to which outputs can be subject to uncertainties

At each stage, various purpose-specific trade-offs are required. For example, organisational resilience analysis should explore a range of plausible outcomes with lower levels of certainty and coarser levels of granularity (unless otherwise specified by the narrative, eg by a sector-specific aspect). Whereas for determining capital adequacy, a lower level of uncertainty can be tolerated and higher granularity is required, particularly in bottom-up exercises.

This page was last updated June 28, 2023

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