Assessing the immediate climate financial risks in NGFS’ short-term scenarios

The imperative to quantify climate-related financial risks is no longer a long-term challenge but a near-term necessity. Climate change requires this quantification to be carried out in a forward-looking way using scenarios, which are crucial in investment decisions, risk management and regulatory measures. The short-term climate scenarios released by the Network for Greening the Financial System mark a significant advance in this effort.

Scenarios are a key tool in risk management. They aim to address whether a financial institution can withstand severe, but plausible, future situations. However, the NGFS’ climate scenarios are not forecasts. Rather, they are coherent pathways along which the economy can develop considering the remaining carbon budgets, technological feasibility and policy ambition.

These scenarios analyse how acute climate physical and transition risks could impact our financial systems over the next five years, providing macroeconomic and financial risk variables to quantify them.

Short-term climate scenarios narratives up to 2030

The NGFS outlines four narratives of how extreme weather events and transition risk could unfold and potentially compound. The first, ‘Highway to Paris’, envisions a gradual but ‘orderly’ and technology-driven transition, in which carbon tax revenues are reinvested into green subsidies and investments. A second, more disorderly transition scenario is the ‘Sudden wake-up call’. This would result from a sudden change in policy, as well as a shift in consumers and investors’ preferences, triggering a ‘climate Minsky moment’.

A third scenario, ‘Diverging realities’ outlines the potential of physical climate risks – particularly in emerging and developing economies – to ripple through global trade and financial linkages onto advanced economies. This, in turn, disrupts supply chains as well as access to critical raw materials, delaying the low-carbon transition.

The fourth scenario, ‘Disasters and policy stagnation’ describes a world in which trade and financial linkages spread the negative impacts of physical risks across the world, amplifying financial and economic instability.

These narratives are translated into shocks on macroeconomic, monetary policy and financial risk variables (including sectoral probability of default, scenario-contingent financial valuation of stocks, corporate and sovereign bonds) for 50 sectors and 46 countries/regions. Shocks account for the impact of markets’ expectations, trade flows, supply chains disruption and financial linkages as a potential risk amplifier.

A new modelling framework for better climate risk assessment

The short-term NGFS’ modelling framework combines physical and transition risks at a granular sector and country level, providing relevant and ready-to-use results to central banks, supervisors, investors and policy-makers.

This architecture integrates three models: GEM-E3, a computable general equilibrium model for economy-energy-environment variables at a high level of granularity; EIRIN, a Stock-Flow Consistent macro-financial model used to project inflation and monetary policy; and CLIMACRED, a climate credit risk model that allows for scenario-contingent valuation of corporate and sovereign bonds and equity.

Key innovations and why they matter for risk assessment and supervision

First, the economic and financial impacts of climate risks are assessed within a time frame of five years, up to 2030. This increases the scenarios’ relevance for decision-makers and stress-test exercises.

Second, climate tail risk – extreme events that are highly damaging and yet have already occurred – are included, and so is the fact that natural disasters do not occur in isolation but can compound in space and time. For instance, extreme wet events, such as floods and storms, as well as dry events, like droughts, wildfires and heatwaves, can take place during the same year.

Third, two narratives combine physical and transition risks. This is a starting point for capturing the interplay of geopolitical, economic and climate risks. In this regard, the baseline is calibrated using the 2023 International Monetary Fund projections. The impact of large, geopolitical and global shocks such as the Covid-19 pandemic and the 2022 energy price crisis that followed the war in Ukraine are also considered.

Fourth, short-term spill-over effects of both transition and physical risk are transmitted through trade linkages, financial markets and disrupted supply chains at the global level.  The financial sector, credit risk and the real economy-finance feedback loop are explicitly modelled and ready-to-use financial risk variables to be plugged into risk assessment models are also provided, such as for insurance and banking.

Climate risk can be material, now

Economic shocks can trigger financial stress, leading to a relevant increase in firms’ probability of defaults in many sectors. Financial linkages can then amplify and spread these shocks. However, the NGFS’ climate scenarios show that the economic impacts stemming from immediate climate risk stand to be much larger than previously estimated – even in the short term, where it can be more relevant for regulatory and supervisory purposes.

Irene Monasterolo is Professor of Climate Finance at Utrecht University, CEPR research fellow and visiting professor at WU Wien.

The modelling consortium is composed by E3M, IIASA and CLIMAFIN, who led the consortium.

Read the full NGFS documentation here.

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