Risk managers urge consolidation of climate scenarios

Converging financial and corporate scenarios would provide better data for stress-testing

Risk management experts are urging financial regulators to consolidate their climate risk scenarios with those produced by the International Energy Agency (IEA). They believe this would make it easier for banks to collect the data needed from corporate clients to model climate risk.

At present, the financial regulators’ Network for Greening the Financial System is producing its own scenarios – most recently in June 2021 – for use in activities such as the climate stress-testing of banks.

“Globally, I think we need to converge around a central scenario that everybody recognises,” says the head of climate risk at a European global systemically important bank (G-Sib). “The IEA scenarios are recognised for emissions pathway calibration and the NGFS scenarios have been developed for stress-testing – I think there would be value in converging the two and having one consensus for everyone on scenario pathways and stress-testing.”

In a report published on July 7, the Financial Stability Board (FSB) highlighted data shortcomings as a key obstacle to monitoring climate risk in the financial sector and promoting an economy-wide transition to net zero carbon emissions.

“A growing number of firms (both financial and non-financial) disclose data on their exposures to climate-related risks,” the FSB noted. “However, absent globally consistent international reporting standards of the sort that apply to other financial risks, such disclosures lack consistency across firms, sectors and jurisdictions.”

In particular, the FSB flagged up the need for more consistent and granular data on financial institutions’ climate exposures in some jurisdictions, and on the impact of physical risks, such as severe weather events and transition risks from policy changes to combat climate change.

Wim Bartels, partner for sustainability at KPMG Netherlands and a member of the FSB-backed Task Force on Climate-Related Financial Disclosures (TCFD), agrees that consolidation would help banks calculate their exposure to companies in sectors where it is hard to abate climate risk, and those that are particularly exposed to physical risks.

“If we are looking into investments in the energy sector or the utility sectors and the extractive resources sectors, you could now make an agreement on how to report on scenarios,” Bartels says.

Charles Donovan, executive director of the centre for climate finance and investment at Imperial College London, explains that reference scenarios are useful to allow firms to test their own performance against a standard view. For that reason, he argues, “there is a necessity for a reference point for signposting for a broader swathe of the economy, which would include a lot of different agents.”

However, he adds: “For systemically important financial institutions, that is only a starting point for their own work on really getting to grips with near-term financial risk, and I think they understand that.”

One step at a time

The IEA’s Net Zero Emissions by 2050 scenario is based on detailed modelling of the energy sector for energy supply, energy demand, gross electricity generation and electrical capacity, carbon dioxide (CO₂) emissions from fossil fuel combustion and industrial processes, and selected economic and activity indicators.

The TCFD framework is used as a common guide for financial reporting to orient the financial and non-financial sectors in the same direction. A common set of scenarios would take that a step further, helping companies in the real economy articulate their estimates of projected losses and earnings from climate change in a way that dovetails with the information that banks need for their own risk engines.

“We [would] agree between us so that we have an indication of where it is going, and we can create consistency across the financial institutions and between the different central banks,” Bartels says.

I would not promote for central banks to come out with their regulation directions by 2022. If you do [it] that soon, then financial institutions start to work with data and approaches that they do not understand 

Wim Bartels, KPMG and Task Force on Climate-Related Financial Disclosures

He believes the IEA and NGFS could harmonise scenarios over the next two to three years, but cautions against acting prematurely before firms have had a chance to improve their capabilities within the existing framework.

“I would not promote for central banks to come out with their regulation directions by 2022. If you do [it] that soon, then financial institutions start to work with data and approaches that they really do not understand – and that increases the risk rather than lowers it,” says Bartels. 

He compares the NGFS scenarios with TCFD, where he says most major companies have now been through four or five rounds of the complex annual disclosure process. That timeline allowed enough opportunity for firms to establish and then harmonise best practices.

Growing pains

Risk management experts also think the focus on a consolidated set of scenarios is an opportunity for regulators to improve the quality of the scenario-setting itself.

“You have inherent, irreducible uncertainty, so I think they certainly could make progress in how they calibrate the various components of the scenario to reduce the uncertainty range around what they do,” says the G-Sib head of climate risk. “They are working hard on tipping points [which] are one of the factors that could create additional volatility around the macro variables.”

The integration with the IEA scenarios could also prompt the NGFS to pay more attention to some of its own macroeconomic assumptions, given the level of uncertainty around them. Benoit Genest, partner at the consultancy Chappuis Halder, questions some of the macro modelling currently used by the NGFS.

“If we really want do stress-testing, the models we are using right now are insufficient,” says Genest. “We have to embrace all kinds of scenarios and all kinds of theories – we have to do a real stress test on the banking sector.”

In particular, he points to the steady economic growth rates included in every NGFS scenario –even for the no-action scenario that carries the greatest physical risks. As a result, Genest warns, potential losses in the banking sector will be underestimated if, in reality, growth slows, and even more so if the economy begins to contract.

Editing by Philip Alexander