Navigating the fog of climate scenarios - top 10 takeaways

Last month there were a flurry of publications linked to #climatechange scenarios. I’ve provided my top 10 takeaways from these here, split into 3 sections (with a note of the publications this is based on at the bottom). Headlines:

• Globally – business as usual no longer exists, we are experiencing climate impacts today and businesses need to assess risks plot a course through the disruption
• Regulators – some consensus and commonality emerging – expect standards in due course, as well as net zero scenarios and enforcement in due course
• Market practice – a huge range, leaders now embracing #RaceToZero and #sustainablefinance, recognizing key role of finance in achieving Paris goals 

This is by no means comprehensive as there is a high volume of literature emerging on this almost continuously, so my sincere apologies for any glaring omissions (please do comment and I look forward to picking up in due course) and to authors for any errors of interpretation.

This article is focused on Financial Services regulation and guidance rather than corporate announcements such as BP & Shell writedowns, auditor implications, stewardship & recent AGM climate resolutions, #RacetoZero/net zero announcements, green recovery/build back better etc.

A huge thank you to all the authors and researchers behind these papers – well done.

Globally – there is no ‘business as usual’

1.      The energy transition is underway – “in every country there is a political battle between those who wish to preserve the fossil fuel status quo and those who wish to move to a new green economy”1

The pace of the transition will be critical to temperature outcomes and hence physical impacts. The manner of the transition will be critical to scale of stranded assets and market volatility. Disruption tends not to be orderly, linear or to favour incumbents. There are complicated narratives unfolding across geographies & industries – plotting an informed path through this will be key for firms to successfully navigate the transition. There are very clear investor, insurer and auditor implications.

2.      The high level of physical risk remains very poorly understood, with warming to 1.5?C almost certainly ‘locked in’ by 2050 – with a wide range of outcomes possible in the 2nd half of the century

The probabilistic and uncertain nature of climate modelling is generally not understood. In higher warming scenarios a number of models show global GDP falling off a cliff post 2050 as the increased physical risk environment overwhelms society’s ability to adapt. Further, climate pathways are probabilistic (eg X emissions give a 2/3 chance of keeping warming to 2?C – so a 1/3 chance of failure). Further, few models capture all the elements of the global climate system (eg tipping points such as permafrost melt releasing methane) – consequently the level of risk is almost certainly understated.

1 & 2 mean there is no ‘business as usual’ – firms must go beyond climate scenario ‘what ifs’ to identify a likely route and plan appropriately. Quoting UK Climate Action Champion Nigel Topping "next 18 months will separate the #RaceToZero winners from the losers" - and this is true for FS firms as well.

3.      What’s in ? a degree? Quite a lot as it turns out – hence the drive for net zero for COP26 and the need for net zero scenarios

In 2018 the IPCC published a special report on 1.5?C of warming which was the source of the net zero by 2050 target. It contained a set of 1.5?C GHG emissions scenarios, which pointed to net-zero by 2050 as key to limiting global warming to 1.5?C.

It also contained detailed analysis of the level of risk increase an additional 0.5?C of warming brings – a LOT as it turns out (eg 1.7 billion more people face annual heatwaves at 2 degrees, Mediterranean regions desertify etc) – hence Net Zero being the clarion call for COP26.

My understanding from various conversations is that we expect net zero scenarios to emerge this year.

Financial Services regulation, commonality and consensus emerging

4.      There is a high level of unusually co-ordinated FS global regulatory activity – with UK/EU front and centre

In the space of just 4 working days at the end of June, we had the publication of FCA/PRA guides from the Joint Climate Financial Risk Forum, the publication of 4 papers from the Network for Greening the Financial System (66 central banks & regulators), an EIOPA publication on climate stress testing in insurance, Lords approvals of mandatory TCFD for UK pension schemes and more…with the PRA’s Dear CEO letter following fast on 1 July…

5.      There is now a toolkit firms can use – but it’s a big to do list

The FCA/PRA CFRF guides in particular provide an (extensive) guide for what firms should do. But not trivial to implement and so firms who have not progressed will need to follow the classic gap analysis/implementation approach. Also arguably provides a minimum standard for laggards to be assessed against in due course – surely a when, not an if, given level of regulatory focus on this topic.

6.      Consensus around the types of scenarios is emerging with a variety of quant solutions now available

Scenarios: There is consistency around the orderly, disorderly and hot house scenarios across NGFS, EU and UK. Now seeing additional scenarios around ‘too little, too late’ – ie we change course but not enough to miss the iceberg – and variations around orderly, disorderly with low/high levels of carbon capture. Currently there are very limited net zero scenarios but my understanding is that these are likely to emerge this year.

Maths: Firms can now quantify macro & micro economic physical and transition risks for a range of climate scenarios. Of course there is model risk, uncertainty, heroic assumptions etc but the answers are easily available, albeit need to be used as directional rather than precise answers. As per above, models are very likely to be under-stating risk currently, particularly for physical. There are a number of specialist modelling firms who provide answers to different bits of the jigsaw (physical, transition, micro, macro) – firms will need to decide what they need and also to ensure they understand the assumptions and limitations of solutions they use.

The market - transitioning to sustainable finance – and a role for us all in accelerating this

7.      Climate change maturity is very wide – with leaders accelerating harder

The gap between the leaders and the starters is large and widening. Leaders are accelerating harder, investing more, committing more, managing risks better, ahead on products, ahead on reporting etc. Leaders run standard scenarios but develop a range of bespoke in-house scenarios more aligned with how they think the transition may transpire.

Starters often don’t understand broad scope of what they need to do or how – a real need to make sure they don’t miss the sustainable finance transformation. Given pace and scale of both physical and transition risks it is hard to see how Boards and auditors will continue to be comfortable with firms that have not undertaken work to understand these.

8.      Culture and education are a massive organisational accelerator

Firms with a low level of maturity can struggle to progress quickly. Contrast with leaders for whom carbon literacy is culturally embedded, with top team away days focused on the topic, with training and engagement at all levels.

9.      Financial Services firms are starting to move – commitments to net zero, more aggressive stewardship ‘engage the equity, deny the debt’ – with possibly profound implications

An increasing number of firms are committing to net zero and starting to see significantly more engagement, voting and investment decisions. The ‘Engage the equity, deny the debt’ tactic is one I anticipate more of – ie why would we buy/re-finance the debt of any company not aligned to Paris – which has possibly profound implications for corporate fund raising if significant numbers of debt holders move in this direction. 

10.  We all have a part to play in delivering a better future by accelerating sustainable finance

All of the above combines to give a really significant market opportunity for firms who lead here – and conversely risks for firms who are slow off the mark.

Given the importance of Financial Services to achieving Paris Goals, this really is a win-win, both in terms of delivering a future we can live in and of course commercial success as financial services transforms to become sustainable. As we move towards COP26 everyone working in financial services has a role to play in accelerating this shift.

Chronology: Some of June’s key moments:

Background/context – how (quickly) will the energy transition happen and what do we already know – key points to inform any climate strategy/scenario analysis...

Highly recommend two short WEF papers:

1. “The speed of the energy transition – gradual or rapid” – with obvious temperature implications
2.  “The A-Z of the Energy Transition: Knowns and Unknowns”

Knowns – we need it to happen quickly, continuously falling costs of renewables/EVs etc, fossil peaks have started

Unknowns – policy and societal responses, demand peaks for fossil fuels post covid, pace & scale of tech innovation and disruption

• 1 June 2020 – Ortec/IFOA paper – long term macro-economic impact of climate scenarios

For me this is a good paper with some powerful results, particularly around macro results of different climate scenarios. Appreciate many are modelling this but note the very material impacts and also the caveats around model parsimony almost certainly understating risk

 Spoiler alert – GDP goes off a cliff post 2050 if we fail to transition as physical risk overwhelms society – forecast 70% reduction in global GDP by 2100

“after 2060 the physical impacts on GDP within the Failed Transition pathway overwhelm GDP growth leading to nominal GDP decline. The model’s financial markets projections cease in 2060 as the relationships with the unprecedented downward-trending GDP cannot be reliably determined”

• 18 June 2020 – Bank of England publishes its first TCFD report, reiterating commitment to climate change focus

Andrew Bailey “My predecessor, Mark Carney, made addressing the financial risks from climate change one of the Bank’s strategic priorities – I intend for it to maintain this prominence”.

• 23 June 2020 – moving in the opposite direction – US dept of labor pushes back at ESG investment

General outrage in the ESG community at new proposals that put in place an additional hurdle to evidence that ESG investment returns > non-ESG investment returns (now broadly accepted by the market)

• 24 June 2020 – Network for Greening the Financial System (now consisting of 66 central banks + observers) publishes 4 papers – including 8 climate scenarios for central banks and supervisors.

NGFS eight scenarios consist of three base scenarios consistent with PRA approach + 5 additional scenarios:

- Orderly: Early, ambitious action to a net zero CO2 emissions economy;

- Disorderly: Action that is late, disruptive, sudden and / or unanticipated;

- Hot house world: Limited action leads to a hot house world with significant global warming and, as a result, strongly increased exposure to physical risks.

- 2 additional scenarios included to cover 1.5?C targets with low and high carbon capture

- Orderly & disorderly variants with low and high carbon capture

- An NDC scenario, still high physical risk but lower than hot house 

• 24 June 2020 – EIOPA consultation on climate change insurance stress testing

Builds off and is broadly consistent with NGFS but contains significantly more technical detail around modelling methodologies (I have only glanced at this quickly)

• 27 June 2020 – Lords back amendments to pensions bill requiring schemes to disclose how they will align investment strategies with Paris

“According to the amendment, pension scheme trustees will have to review the impact of climate change on their investment strategy, manage their exposure to these risks and determine targets for their exposure.

Another amendment called for consumer dashboards to include information on how pension schemes’ investments align with the UK Stewardship Code and the objectives of the Paris Agreement.

These amendments would make the UK the first country in the world to align the actions of pension schemes with the agreement.”

• 29 June 2020 – FCA/PRA Climate Financial Risk Forum guides published on risk mgt, scenario analysis, disclosure and innovation. A plethora of strong quotes here

“Leadership and cultural change are critical to deliver the climate risk agenda. Every decision maker at every level of the organisation must understand the importance of reacting to climate risks.”

“It is important that financial institutions fully integrate climate risk into their existing risk management framework. Failure to do so means that firms will be unable to understand and respond to the true dangers it poses to their business models.”

The scenario paper has a lot of good detail but is less prescriptive than regulators in prescribing specific scenarios. It references the SSPs as scenarios which are a bit out of date now.

• 29 June 2020 – Alok Sharma speech at COP26 business leaders event (not strictly speaking about climate scenarios) – strong call to action around net zero

Strong rhetoric from the UK’s COP26 President citing some positives around UK power generation, falling costs of renewables and calling for 4 concrete actions for businesses:

1. Commit to 100% renewable energy (RE100)

2. Accelerate zero emission transport (noting govt plans to accelerate this) – by committing to 100%EV fleets by 2030

3. Finance sector – embrace TCFD

4. Join the Race to Zero Coalition

• 1 July 2020 – PRA ‘Dear CEO’ letter on climate change

Sam Woods writes to CEOs giving them till the end of 2021 to comply with the expectations laid out in SS3/19…tick-tock…

Notes

1.      Thank you Carbon Tracker for this line from “Decline and Fall” – also published in June 2020. I felt it was too good not to use.

All views in this article are my own – not representative of EY, IFOA or Protect Our Winters UK.