Climate Science Vital to “Fill the Gaps” in Scenario Analysis

Ahead of the NGFS’ deadline for feedback on its climate scenarios, experts argue models must be more realistic and robust to give investors decision-useful insights.

Existing climate scenario analysis models have “severe limitations” and risk giving company boards and investors insufficient information to make investment decisions necessary for a just transition, according to industry experts.

“We should expect NGFS scenarios, and others, as they develop is to integrate the climate science from the Intergovernmental Panel on Climate Change (IPCC),” Amanda Latham, Associate and Policy & Strategy Lead at UK-based consultancy firm Barnett Waddingham, told ESG Investor. “At the moment, that forms part of the gap in scenario analysis models.”

The comments come as the Network for Greening the Financial System (NGFS) calls for users and interested stakeholders to submit feedback on its climate scenarios to ensure they remain relevant for a growing user base.

A key limitation of the NGFS scenarios is that they are very sensitive to the initial specifications of the model, which means the final outputs vary wildly depending on a number of factors, such as policies, technologies, and cost functions, according to Francesca Messeri, Commercial Lead for TCFD at the Carbon Trust.

“This can leave users unable to interpret and explain the results of their analyses,” she said. “NGFS scenarios are also not equipped to deal with the effects of external shocks like Covid-19 and the war in Ukraine, meaning outputs could be difficult to contextualise.”

Masseri added that NGFS scenarios are not built to deal with “extreme risk” – catastrophic outcomes associated with lower probability events or fat-tailed distributions – meaning they are prone to underestimating the impact of climate change.

“Nevertheless, it is better to have these scenarios, however imperfect, than not to have them and the NGFS’ receptiveness to feedback from the market is a definite positive,” she said.

The NGFS is a network of 114 central banks and financial supervisors that aim to accelerate the scaling up of green finance which develop recommendations for central banks’ role for climate change.

Bridging gaps

Speaking earlier this month at a City & Financial event on climate transition plans, Kaisie Rayner, Founder and Director of A Future Worth Living In, said: “If you look across the six NGFS scenarios, whether that is Net Zero 2050, Delayed Transition, or Current Policies, have only minimal impacts on GDP and reference against an imaginary world where there are no climate change impacts at all.

Rayner added: “There are some severe limitations around the current scenario analysis […] we are at risk of giving boards incorrect information to make decisions.”

Latham expects the NGFS, and other developers of scenario analysis models, to integrate climate science into their models over time. NGFS scenarios are “exploratory”, said Latham, adding that the idea of scenario analyses is that they are updated and developed to bridge gaps in the models.

She recognises that this is not “ideal for investors” as they require decision-useful information now, not tomorrow. “That is part of the challenge when collaborating around different methodologies and assumptions to build a framework across different disciplines.”

From an investor perspective, if you’re a pension fund trustee concerned about accidental greenwashing, then it’s vital to question the information that’s being put in front of you, she said.

Real data, realistic scenarios

A key challenge for users and developers of climate scenarios is the quality and comparability of underlying data.

The Taskforce on Climate-related Financial Disclosure (TCFD) recommendations are designed to help drive consistent disclosures by companies to enhance investors’ understanding of climate-related business risks and opportunities. Although recently incorporated into regulatory regimes in a number of key jurisdictions, they remain voluntary elsewhere.

This means too few firms are delivering useful climate-related information to investors in line with the TCFD’s 11 recommended disclosures.

Latham stressed that climate scenarios will improve when they’re “based on real information rather than assumptions”.

“As we get the flow of information from mandatory TCFD reporting at the company and asset manager level, supported further by the shift to mandatory transition plans, that should give real information for the models to be based on,” added Latham. “That’s also going to act as a real driver of improvement.”

Mandatory climate-related financial disclosure requirements under TCFD currently apply to all UK publicly listed companies with more than 500 employees, as well as regulated asset managers and owners.

The Transition Plan Taskforce’s (TPT) disclosure framework and implementation guidance are open for public consultation until 28 February. The TPT will then review the feedback and finalise both frameworks, including additional case studies and examples of good practice for implementation.

Later in this year, the TPT will also publish sectoral guidance, including an overview of sector-specific metrics from existing guidance that can supplement the TPT’s disclosure framework. It is currently unclear when transition plans will become mandatory.

Control the narrative

One way in which climate-related disclosures and scenarios can be more “robust” is by providing investors with a clear “narrative” – qualitative information to accompany the quantitative data to provide context around climate-related metrics, said Latham.

“Through a narrative scenario, [investors] can start to think what the real-world impacts might be and allow them to think about risks proportionally [and] where the opportunities to mitigate those impacts are,” she said.

Last year, the Real World Climate Scenarios (RWCS) initiative hosted a series of roundtables focused on addressing the inadequacy of official climate risk scenarios. RWCS is led by Mike Clark, Founder Director of Ario Advisory, a firm that offers responsible investment advisory services to asset owners and managers, Mark Cliffe, Visiting Professor, London Institute of Banking & Finance, and Willemijn Slingenberg-Verdegaal, Managing Director of Climate & ESG Solutions at Ortec Finance.

A summary of the roundtable discussions found that the scenarios being used by central banks and regulators grossly underestimate both the risks and opportunities presented by climate change. Since “narratives eat models for breakfast” it stressed the need for more realistic “qualitative content to fill the gaps that a quantitative approach can’t yet capture”.

The RWCS noted that “many climate models fail to capture acute physical risks, tipping points, path-dependency and complex feedback loops”. Noting that the NGFS’ accepts some of the limitations of its own modelling, the urgent need is develop more relevant short-term scenarios.

Currently, official climate scenario analysis offers “what if” methodological frameworks that explore risks that could crystallise based on different possible futures over long time horizons, which is “no good for practical strategic decision making”, according to Ario Advisory’s Clark.

All users and interested stakeholders can submit feedback on the NGFS scenarios until 27 February.

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