This paper discusses the ways that standard climate scenarios, like those produced by the Network for Greening the Financial System (NGFS), can be used to create short-term stresses for financial markets.
Climate impacts are often expressed as changes to long-term expected returns. For long-term investors, the impacts of lower expected returns can be significant. However, for short-term firms, the impacts of stressing longer-term changes to expected returns are likely to be limited.
We therefore emphasize the importance of understanding both:
- How climate scenarios may impact longer-term expectations for financial market returns.
- How this can lead to potential short-term impacts and market stresses.
We show how this can be done using the NGFS scenarios.
To justify, develop and contextualize our approach, the paper features a discussion on integrated assessment modeling, the impact of climate change on longer-term expected returns, market capitalization adjustments, and incorporating climate and socio-economic tipping points. It also introduces the "Stairway to Net Zero" concept, representing the recurring costs of reducing emissions over five-year periods towards net zero emissions. It highlights the need for a comprehensive examination of marginal abatement costs in models which often overlook important transition costs.
A "Layer Cake" analogy is also introduced, referring to the layered structure of scenario modeling. The paper underscores the importance of this middle layer, including financial economic analyses. We identify two key leverage points - climate and economic sensitivities, and market expectation adjustments. These leverage points can either mitigate or amplify financial shocks and are therefore critical to understanding climate change's potential role as a systematic risk driver and multiplier.
Overall, the paper advocates for a more flexible and advanced standard modeling structure, utilizing existing climate scenario capabilities for exploring non-linear dynamics. Using this flexible approach, we present two alternative scenarios with more severe physical impacts and green growth respectively, and emphasize the need to consider scientific and economic uncertainties in climate change impacts.
The paper concludes that climate change can significantly impact financial markets in the short term. Short-term scenario analysis and stress testing look likely to become a significant focus for regulators (cf NGFS, 2023).
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