All climate scenarios are wrong, but it does not mean they cannot be useful.
The UK Centre for Greening Finance and Investment (CGFI) published a report analysing how financial institutions can properly take them into account along with their hypothesis and limitations for risk management.
Here are a few conclusions from the report:
- Environment- and climate-related risks bring unprecedented challenges for financial institutions compared to other types of risk.
- Financial institutions need to integrate into their risk assessments the probabilities and hypotheses underlying the scenarios to understand their credibility and level of conservativeness.
- Current scenarios show limitations when used for stress testing and risk management, as they overlook critical aspects to understand the severity and timescale of the most material risks.
- Cost optimisation scenario pathways miss potential economic and financial frictions, volatility, and acute physical risk disruptions that can impact stress tests and risk assessments.
- Mainstream scenarios still lack the granularity required to conduct consistent and comparable risk assessments.
- Regulators and financial and academic institutions should collaborate to set up a comprehensive scenarios taxonomy to build more relevant decision-making ones whose limitations can be understood by all.
The CGFI argues the currently accepted scenarios rather lie on the lower end of the range of plausible future risk, potentially giving rise to a false sense of security on how the transition may unfold.
These conclusions stress the importance of regulators and financial institutions quickly enhancing their environment- and climate-related risk management to lower the risk of misinterpreting the outcomes of climate scenario analysis.