Technical supplement to the First NGFS Comprehensive Report

1. Introduction

 
Climate change is one of many sources of structural change affecting the economy and financial system. However it has several distinctive characteristics that mean it needs to be considered and managed differently. These include:

• Far-reaching impact in breadth and magnitude: climate change will affect all agents in the economy (households, businesses, governments), across all sectors and geographies. The risks will likely be correlated and, potentially aggravated by tipping points and non-linear impacts. This means the impacts could be much larger, more widespread and diverse than those of other structural changes.
• Foreseeable nature: while the exact outcomes, time horizon and future pathway are uncertain, there is a high degree of certainty that some combination of increasing physical and transition risks will materialise in the future.
• Irreversibility: the impact of climate change is determined by the concentration of greenhouse gas (GHG) emissions in the atmosphere and there is currently no mature technology to reverse the process. Above a certain threshold, scientists have shown with a high degree of confidence that climate change will have irreversible consequences on our planet, though uncertainty remains about the exact severity and time horizon.
• Dependency on short-term actions: the magnitude and nature of the future impacts will be determined by actions taken today, which thus need to follow a credible and forward-looking policy path. This includes actions by governments, central banks and supervisors, financial market participants, firms and households.

The risks from climate change arise from two sources: physical and transition.

Physical impacts are those that could arise from climate and weather-related events, such as droughts, floods and storms. They comprise impacts directly resulting from those events such as damage to property. They can also have wider systemic, as well as firm-level impacts, for example through disruption to global supply chains. Longer term progressive shifts in the climate (such as changes in precipitation, extreme weather variability, sea level rise and rising mean temperatures), and adaption to these changes, may also have implications for the economy, such as on productivity, migration and the reconstruction and replacement of infrastructure.

These changes could also potentially result in large financial losses. If losses are insured, they can directly affect insurance and reinsurance firms through higher claims. If losses are uninsured, the burden can fall on households, corporates and governments. This can impair asset values, reduce the value of investments held by financial institutions and increase credit risks for banks and investors. Since the 1980s, the annual number of registered weather-related loss events has tripled. Overall losses  amount to four times the size of insured losses on average and the protection gap continues to widen (Geneva Association, 2014).

Transition impacts are those that relate to the process of adjustment towards a low-carbon economy. Emissions must eventually reach "net zero" to prevent further climate change. The scale of the economic and financial transformation required for this transition is considerable. For example, the Global Commission on the Economy and Climate (2018) estimated that globally around $90tn will need to be invested in infrastructure in the urban, land use and energy systems until 2030.

This transition will also be relevant to the financial system. Changes in climate policies, technological innovations or market sentiment could prompt a reassessment of the value of a large range of financial assets as changing costs and opportunities become apparent. The speed at which such re­ pricing occurs is inherently uncertain but, given the scale, its impact couId well be important for financial stability and the safety and soundness of financial firms.

The assets which could be impacted are not just limited to sectors involving the production or distribution of fossil fuels, such as coal, oil, or gas. They also include utilities, heavy industry, petrochemicals, cement, transportation (including aviation and shipping), real estate, and agriculture - essentially all sectors that are energy, or otherwise emissions-intensive and couId therefore be affected by policies to reduce GHG emissions. lnvestment in emissions-intensive assets today has the potential of locking in a certain amount of future GHG emissions. Power plants, for example, have an operational life of several decades. These assets could be at risk of stranding if they are retired before the end of their productive lifespan, for example due to policy change.

Understanding macro-financial changes is a core part of central banks' and financial supervisors' responsibilities. This paper aims to summarise the academic work done to model the  impact  from climate change on the economy and on the financial system, to  set out indicators that can be used to monitor these risks (see Annex 1) and identify some of the areas for further research (see Annex 2). While the ranges of estimates from models are sensitive to the assumptions used, they do describe significant transformations across different sectors of the economy to either mitigate or adapt to the risks. These changes could also manifest as risks to the financial system, particularly if the transition to a low-GHG economy is disorderly.

The paper also sets out a menu of options for central banks and supervisors to assess the risks. ln particular, it sets out some preliminary views on how scenarios can be used to simplify the analytical exercise by providing a plausible narrative to anchor model inputs and assumptions and so help size the economic costs and financial risks from climate change.