It’s Time for Climate Scenario Analysis to Evolve

Even for financial institutions as sophisticated as the Bank of England (BoE), the transition to a net-zero economy continues to be a complicated task.  

Last month, BoE staff published an article on tackling these challenges through the medium of climate scenario analysis (CSA). Such analyses are used to explore the potential future impacts of climate change on the economy and financial system, and thereby help institutions craft strategies to manage climate risks and leverage climate opportunities.

Conducting CSAs that produce decision-useful information for financial institutions is no small task, however. Banks, asset managers, and asset owners need information on how our changing climate – together with the policy, technology, and market responses it engenders – could impact individual assets and investments. Data at this level of resolution is crucial if we want to see financial institutions react nimbly to the climate challenge.

However, as the BoE article notes, the popular “macro scenarios” used today generate broad pictures of the future rather than the more granular images that firms need. Something must change if CSAs are to be made truly useful to investment decision-making.

The Challenge of Macro-Climate Scenarios and Asset-Level Analysis

Addressing this, the BoE underlines the necessity of “extending” macro scenarios to produce insights at higher spatial and temporal resolution, and to accommodate intra-sectoral variability.

Amos Wittenberg

After all, climate change risks and opportunities are likely to unfold differently depending on region and timescale, and to impact companies and asset classes in varying ways. CSAs should reflect this heterogeneity, helping financial institutions derive a more detailed and practical understanding of the risks faced by specific assets in their portfolios.

The BoE highlights its own approaches to “extending” scenarios across the three asset classes it is most exposed to: sovereign bonds, corporate bonds, and residential mortgages. Their analysis demonstrates the various pathways through which different climate scenarios can impact financial valuations, from changes in sovereign yields due to policy responses and credit risks, to corporate valuation adjustments based on transition and physical risks, and even to residential mortgage pricing affected by energy costs and flood risks.

What “extending” looks like in practice differs by asset class. When it comes to sovereign bonds, the BoE says it produced additional interest rate variables by interpolating the short-term debt and 10-year yield projections included in preexisting scenarios, as well as extrapolating over longer time horizons. This allowed it to estimate how yields on a broader range of sovereign bonds could bounce around over time under different warming scenarios. In the context of corporate bonds, meanwhile, the BoE says information on how carbon prices affect individual companies is necessary to produce a useful rendering of their vulnerability to a greener future.

The Bank’s work in these areas highlights the large variation in risk across assets, even within the same class, such as the disparate impacts of a disorderly transition on corporates in different sectors or the marked difference in residential energy costs by EPC rating.

Limitations and Continuous Evolution of Scenario Analysis

Extending macro scenarios in the ways described by the BoE may help produce outputs that bring a fuzzy picture of asset-level risks into sharper focus. However, true clarity requires a deeper approach to data analysis and a more nuanced understanding of the intricate interactions between climate, economy, and financial markets.

This starts with a necessary overhaul of how financial institutions classify companies. The climate transition will produce winners and losers within and across sectors, based less on

pre-existing sector fundamentals and more on the resources, expertise, and flexibility they can leverage to handle the changes to come. Sizing up companies based on this “adaptive capacity” can give institutions an edge identifying potential transition leaders and laggards.

Financial institutions may also consider bottom-up modeling of a corporates’ transition risk sensitivity. This can complement and improve on the top-down modeling approach offered by macro scenarios, allowing the idiosyncrasies of each company to come to the fore and inform the ultimate view of their transition risk and opportunity exposure.

Engaging with and investing in such efforts will be crucial to ensure financial institutions practice effective risk mitigation and align their investing activities with global climate goals.

Amos Wittenberg is CEO of Unwritten, a climate analytics and modelling provider for the financial sector. Prior to founding Unwritten Amos launched Palantir Technologies' climate data team and before that, covered financial crime and terror financing as Editor in Chief of KYC360.