New supervisory practices – Summary

Climate scenario analysis is a risk assessment tool that provides a “what if” methodological framework to examine how climate-related financial risks might materialize in possible future states. Unlike traditional risk models based on historical data, scenario analysis is useful in assessing climate-related financial risks due to the significant uncertainties associated with climate change.

In the financial sector, climate scenario analysis is an important tool used by both regulators and financial institutions to assess climate-related financial risks. This summary provides an overview of the Network for Greening the Financial System (NGFS) climate scenarios¹ and is based on the 2022 report Analysis of climate scenarios by jurisdiction: initial findings and lessons learned published jointly by the NGFS and the Financial Stability Board (FSB).

Objectives of the climate scenario analysis

In practice, regulators use climate scenario analysis for a number of purposes, including to assess:

• How climate-related risks can affect financial stability (a macroprudential perspective)
• how climate-related risks can affect individual financial institutions (a microprudential perspective)
• what environmental factors and risks may affect insurers, as set out in the Insurance Principles of the International Association of Insurance Supervisors

Most of the countries studied pursue multiple objectives with climate scenario analysis. Most commonly, such analysis is used to assess how climate-related risks could affect individual financial institutions at the microprudential level and financial stability at the macroprudential level. It is least commonly used to formulate climate-related government policies.

Financial institutions use climate scenario analyses to assess their climate-related risk positions and to meet disclosure requirements, for example under International Financial Reporting Standards (IFRS).

Conducting a climate scenario analysis

When conducting a climate scenario analysis, regulators typically use one of three different approaches: a top-down approach²a bottom-up approach³ and a hybrid approach. The most common approach is top-down.

The following stylized example with the four main steps could help both regulators and financial institutions to conduct a climate scenario analysis:

	Step 1: Identify the objectives of the exercise and choose the time horizon.
	Step 2: Select the relevant climate scenarios. The NGFS scenarios provide regulators or financial institutions with a common starting point to analyze climate-related risks to the economy and financial system. They can modify these scenarios to make them more relevant to a jurisdiction or entity. They can also use non-NGFS scenarios. Using a selection of different scenarios can provide a more comprehensive view of possible outcomes.
	Step 3: Assess the impact of climate risks on economic and financial variables. Regulators use a range of methods to model these impacts. They are working to combine models and improve macroeconomic modeling to calibrate it more accurately.
	Step 4: Communicate the results along with the key assumptions underlying them. This is intended to provide a basis for follow-up actions to improve risk management practices in financial institutions.

The NGFS scenarios

The NGFS scenarios were developed primarily for the purpose of risk assessment, with a focus on the impacts on the economy and the financial sector over long periods of time.

Currently seven⁴ NGFS scenarios provide a range of plausible outcomes for how climate change, climate policy and technological trends could affect the economy and financial system. The most commonly used scenarios are current policy, net zero 2050 and delayed transition. These scenarios examine the risks that would arise from a greenhouse world.⁵orderly⁶ and disordered transitions.⁷

The NGFS will publish new shorter-term scenarios with time horizons of three to five years. Short-term scenarios can overcome limitations in macroeconomic and financial risk analysis, particularly long-term climate-economy relationships captured in the current NGFS climate scenarios.

Results of climate scenario analyses

In most of the countries studied, the disorderly transition scenario had the most severe impacts, resulting in a decline in gross domestic product and increasing financial losses. In both the disorderly and orderly transition scenarios, carbon-intensive sectors, including oil, gas and coal production, were most affected.

In high physical risk scenarios, where natural disasters are more frequent and severe, most local sectors, including agriculture, mining and construction, could be significantly affected. For example, severe floods concentrated in a specific geographical area or densely populated areas can amplify the impact on local sectors.

challenges

The main challenge in conducting climate scenario analysis relates to the availability, consistency and comparability of data. For example, data on a bank’s counterparty’s greenhouse gas emissions may not be available or may not be sufficiently detailed. This can limit financial institutions’ understanding of their counterparties’ vulnerability to transition risks. Authorities are using internal models, expert opinions and third-party data sources to fill the data gaps. The recently published IFRS principles for disclosure of sustainability-related financial information (IFRS S1) and climate-related disclosures (IFRS S2) should also help fill data gaps. These standards require financial institutions to disclose sustainability and climate-related information.

To improve climate scenario analysis, it is crucial that financial institutions and regulators work together across borders to share best practices between jurisdictions. Global collaboration will help create a common framework that balances standardization and comparability with local specificities.