The Climb to Net-Zero with NGFS Climate Scenario Analysis

Learn more about Climate Credit Analytics

The transition to a low-carbon economy is surrounded by several uncertainties, including: 

• Multiple temperature pathways. 
• Shifting government climate policies.
• The role of technological change and the opportunities it creates.
• The reaction of households and companies. 
• Related financing. 

This poses a challenge for central banks and supervisors in defining their response to climate risk. While they’ve widely accepted that scenario analysis, with its ‘what-if’ approach, is better suited to the exploration of the impact of climate change than traditional risk modeling techniques, a standardized framework to simplify the myriad possible pathways is still needed.

The creation of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) in 2017, with only eight central bank members at the time, has been instrumental in addressing this issue of standardization. Today,^[1] the NGFS consists of 108 members and 17 observers, demonstrating the wide acceptance of its climate scenario framework, which is a crucial step forward in assisting the entire financial system in evaluating the financial impact of climate risks. Corporations that are dependent on the financial system are looking to address their strategy and appreciate the much-needed direction on climate scenarios provided by NGFS. This is especially the case for those corporations that are committed to the Task Force for Climate-related Financial Disclosures (TCFD).    

The NGFS released Phase 1 of its climate scenarios in June 2020. While this provided a solid foundation, there was still room for improvement in considering regional idiosyncrasies, integrating transition and physical risk, and improving the representation of technological change. Nevertheless, following this, several central banks initiated an analysis of stress that climate risks impose on the financial system. Phase 2 of the climate scenarios, which was released in June 2021, saw a better reflection of the totality of risks that we face, including physical and transition risks, economic risks, and financial risks. 

There are now nearly 1,000 variables involved across scenarios and countries, providing much more granular information than before. The scenarios have also been updated to include emerging policy consensus to reach net-zero emissions by 2050 and the impact of the COVID-19 pandemic on economic growth. The NGFS acknowledges this to be a fast-moving field and, in drawing a parallel to climbing Mount Everest, mentions that we are now somewhere past the base camp. There is scope for more detailed sectoral analysis and for expansion of physical risks to account for acute events, such as floods and cyclones. In future phases, the NGFS is expected to continue to extend its analysis and incorporate these aspects.

While the NGFS has provided a framework for climate scenarios, the inability to link these to the drivers of financial impact, along with a lack of data and inconsistent disclosures, poses issues for financial institutions in conducting analysis and making credit decisions. Moreover, the fact that climate scenarios will continue to evolve, means that the approach to analysis may need to be altered, requiring dedicated resources and manpower with relevant experience. 

To assist our customers in overcoming this challenge, we have developed off-the-shelf offerings that enable a bottom-up counterparty- and portfolio-level analysis for both public and private companies across multiple sectors globally. This can be done in a relatively consistent, transparent, flexible, and scalable manner.

The offerings include Climate Credit Analytics, developed in collaboration with Oliver Wyman,^[2] which is a bottom-up analysis using scenarios aligned to the NGFS, supporting comprehensive and consistent sector-specific modeling. This includes an evaluation of key high carbon-emitting sectors. Climate Credit Analytics is complemented by Climate Risk Gauge, a top-down market valuation approach that evaluates the impact of carbon prices on select financials and future market capitalization of companies in a chosen sector, scenario, and year, generating a credit risk score.^[3]  The two tools reflect the latest climate scenarios and methodologies, enabling companies to remain on track with changing market dynamics and regulations.

While nothing is as problematic as predicting the future, the offerings come embedded with scenario analysis, as well as robust underlying data on companies, emissions, and industries. They are designed to meet the needs of financial institutions on this complex subject matter and provide the necessary insights to make decisions with conviction.

For more information, please refer to https://www.spglobal.com/marketintelligence/en/solutions/climate-credit-analytics