Climate scenario analysis understates true risk, warn global supervisors

The FSB has called on central banks to work across jurisdictions to overcome data and modelling limitations.

Climate change from drought to green growth

The Financial Stability Board (FSB) has challenged prevailing thinking that the financial impact of climate change will be severe in only a handful of cases, and limited to carbon intensive sectors.

Scenario analysis conducted by the Japanese central bank earlier this year found that local banks would be able to absorb the costs of climate change relatively easily, while a separate exercise by the European Central Bank found that only a third of bank exposures would be impacted.

The conclusions are in line with many central bank exercises that do not find severe impacts under a scenario where climate policies are introduced early and in an orderly manner, but report significant GDP and financial losses for disorderly and no-transition scenarios. The findings also suggest that losses are contained within a handful of sectors when they do occur.

According to joint research published today by the G20 supervisory body and green central banking group NGFS, climate-related risks are “likely understated” since scenario analysis exercises do not capture second-round effects, such as losses borne by insurance companies and the costs of risk management measures introduced to limit losses.

The scarcity of available data and modelling limitations also remain key challenges for climate scenario analysis and could contribute to the understatement of risks, the FSB said.

The research is based on data from 67 scenario analysis exercises, of which 35 had been completed, 19 were in progress, and 12 were in the planning stage. A total of 53 central banks participated in the research.

Supervisory climate scenarios issued by the NGFS played a critical role. The majority of central banks used or adapted the scenarios, and they were a point of reference for the remaining supervisors. NGFS scenarios are considered more conservative than climate scenarios issued by the International Energy Agency (IEA), which are used by investors to assess the resilience of their portfolios.

The FSB has called for greater cross-border cooperation on scenario design, modelling approaches, and data and developing guidelines for scenario analysis.

FSB chair and Dutch central bank president Klaas Knot said that improving scenario analysis would be crucial to enhancing the understanding of financial sector vulnerabilities. “A key priority going forward will be to enhance the understanding of how first-round and second-round effects under different scenarios could give rise to financial stability concerns,” he said.