However, it is clear - based on the regulator’s expectation - that scenario analysis and stress testing will become the cornerstone of the climate risk framework. The institutions will be challenged to come up with a credible set of transition scenarios and attaching a macro-economic impact to each of them. Modelling the transition to a sustainable economy is not straightforward as the carbon emissions are the output of the complex interrelationship between economic growth, demographic evolution, used energy mix, the energy intensity of the economy and regulatory action. Moreover, these relationships can become unstable due to the potential emergence of new developments such as the advent of carbon capture technology. This being said, IAMs (Integrated Assessment Models) are proving to be quite powerful in mapping the complex dynamics of the above-mentioned drivers of the carbon output and could thus provide a starting point for the quantification of the climate scenarios.
For the second main aspects, the definition of the potential scenarios, NGFS (Network for greening in the financial system) can be considered a great starting point as shown in Figure 1. While these scenarios have originally been developed to supportcentral banks and supervisors, it is easy to adopt them for climate related scenario analysis or climate related stress testing models.
Each of the portrayed scenarios can be linked to Carbon Budget, which is an expression of how much Carbon (Gigatons CO2) will be emitted at each point in time. Explained differently, the scenarios allow us to define a logical evolution of the CO2 emissions (or Carbon Pathway) over the coming decades, which will serve as the restriction during the application of the AIM models. The output will be a set of pathways in terms of economic growth, population and energy usage that all correspond to the carbon budget defined under each scenario. The number of possibilities can be further narrowed down by using the input of both internal and external experts and eliminating the least realistic predictions. Ultimately, the IAM model should provide predictions of macro-economic pathways that can be used as inputs for stress testing.
Figure 2: NGFS Climate Scenarios Framework