Criticism of climate scenarios is the Mary Poppins bag of responsible investment. The amount of things you can pull out seem endless: Too long term, too macro, too ambitious, not ambitious enough, not considering this tipping point, not considering that parameter, not considering fiscal policy, network effects, etc, etc, etc.
Poor modelling community! They developed an ecosystem of models designed to respond to a specific set of questions posed to them by policymakers and now find themselves in the unenviable position of having to shoehorn this infrastructure into a fundamentally different use case.
To their credit, much has been done to improve the usability of transition scenarios over the past few years – the NGFS short-term scenarios released last week are just the latest example.
But in this case, a spoonful of sugar still doesn’t make the medicine go down. There is still one fundamental flaw that remains unaddressed and it’s a relatively simple one:
People don’t believe in them.
And I don’t mean that people don’t believe in the transition (although undoubtedly some do not). That wouldn’t necessarily be a problem, after all, there are also the hot house scenarios on offer.
No, nobody believes in any of them. Hot house, cold house, fugayzi, fugazi. It’s a whazy. It’s a woozie. It’s fairy dust…
Let’s take the latest NGFS short-term scenarios as an example. The divergent reality scenario that forms part of this new suite has “advanced economies pursue a net-zero transition in line with Highway to Paris”. The USA is in the top five fastest decarbonising economy in that scenario, reducing emissions by 40 percent between 2024 and 2030.
Genuine question: What are we doing?
How is a scenario analysis exercise using such a scenario useful (beyond the obvious messaging issues it sends as to the ‘good’ Western economies versus the rest of the world)?
The core principle of course is correct. The NGFS had the right idea. We are in a divergent reality.
I would wager that most people would agree that the next 5-10 years will see some markets accelerate decarbonisation, and some slow, some sectors see massive uptake of clean technologies and some lag. Some policies will be achieved, some accelerated, some missed.
That is the reality that most investors that I talk to believe in. But neither the NGFS nor the IEA scenarios describe that reality.
This tension at the heart of climate scenario analysis can be summarised in two sentences. People allocate capital based on the future they believe in. And so by extension, until people believe in the climate transition scenarios, they won’t meaningfully allocate capital on that basis.
And until we address this tension, even when we find that climate scenarios have become “Practically perfect in every way”, they still won’t do the job.
I will readily admit I did not fully appreciate this fissure until quite recently, despite having worked on scenario analysis for over a decade. Alignment tools – the first generation of scenario analysis models – were never designed to show the likely future, but what was needed to “align” with climate goals.
Stress tests in turn similarly were not about conviction, but extreme outcomes. By that measure, NGFS scenarios for risk exercises don’t need to be plausible baselines.
At some point, however, it is time to allocate capital. To do that, we need to believe in the transition.
There is good news. First, the “excuse” that the radical uncertainty of the climate transition makes “transition forecasting” a silly exercise no longer flies. The maturity of many transition technologies makes forecasting much easier than 10 years ago.
Second, people are actually way more optimistic about the transition than they realise. A survey of IPCC scientists published in a Nature article last year highlighted that the overwhelming majority believe we will reach net zero in this century, consistent with warming around the 2C mark, according to IPCC scenarios.
While far away from 1.5C, these projections are significantly more optimistic than the 3C narratives we’re used to. And from an investment perspective, highlight that the transition is a long-term investment theme that is here to stay…even if the west wind blows.
The reality, of course, is that investors currently do forecast the transition already. Their capital allocation is the tell in what future they believe in.
The obvious problem: these forecasts are implied, not explicit. Nor do investors in most cases even know whether they are a “bear” or a “bull” on transition themes. Indeed, in a divergent reality world, you may find yourselves an optimist in one market and a pessimist in another.
Finally, when making them explicit, investors may realise their views don’t actually align with their capital allocation approach.
The problem is increasingly recognised.
The new PRI Pathways highlights the importance of forward-looking analysis based on “forecasting” and “anticipated shifts in markets”. In the work I do for the Inevitable Policy Response, I see an obvious demand to develop “in-house” views on the transition.
Regulators are asking for it, too. The recent Bank of England consultation paper on climate risks makes clear that regulated entities need to “justify” their scenario choice.
How can you do that if you don’t undergo an exercise to build conviction? And will going to market with a scenario where the US decarbonises by 40 percent in the next six years be something you think you can “justify”?
In the Mary Poppins book, Mary Poppins says to Jane and Michael: “Don’t you know that everybody’s got a fairyland of their own?”
On the transition, the desire for harmonisation has caused us to lose sight of that reality. Investors each have their own views. Time to explore these fairy tales! After all, who knows, some of them might become reality…
Jakob Thomä is co-founder of Theia Finance Labs (formerly Two Degrees Investing Initiative), research director at Inevitable Policy Response and professor in practice at University of London SOAS.
