The importance and limitations of short-term scenarios
By David Carlin in partnership with Unwritten
Climate change and the transition are here. Yet too many risk models are still focused on 2050 and beyond. That needs to change.
A couple of weeks ago, I talked about the limitations of long-term, linear climate scenarios for financial decision making. One solution: short-term scenarios.
Widely used long-term climate scenarios like those from the NGFS typically run to 2050 or beyond, with impacts in five-year increments. Short-term scenarios, by contrast, focus on just the next five years. This can make them much more relevant for decision makers. The tenure of corporate leaders and elected governments, the holding period of most assets, and the timeline for decisions in general is closer to five years than twenty-five.
There is still a huge amount of uncertainty over a five-year time period. But short-term models are less sensitive to assumptions and better suited to being probabilistic (working forwards from what we know today) rather than deterministic (working backwards from a predetermined endpoint).
The NGFS got a lot of attention when it released a set of short-term scenarios in May. Vivek Gandhi is Director of Economics at Unwritten and helps investors use scenarios for climate risk assessment. He explains that while long-term scenarios are better suited for understanding structural changes, these new short-term scenarios explore the interplay between climate risks and business cycles.
“For example, they show that even a brief delay in transition efforts can significantly increase financial risk, as ongoing disruptions from physical damages compound with more stringent climate policy. The Sudden Wake-up Call scenario projects steeper GDP losses if these policies are delayed by just three years, driven by supply chain disruptions and rising default probabilities.”
“However, there are some important differences in how they work; they can’t be switched out like-for-like with long-term scenarios. The long-term scenarios output hundreds of economic variables that can be downscaled to offer trajectories for company revenues and costs. By comparison, the short-term scenarios focus on macroeconomic and financial variables such as cost of capital, bond spreads, and default probabilities. Investors can build these variables into existing cashflow and credit models, or alternatively can take macro variables such as GDP as indicators of general market conditions.”
Another limitation of short-term scenarios is that they can’t tell us about the extent to which investing in the transition avoids long-term financial damage from the physical impacts of climate change. That’s because the physical risks we are exposed to over the next five years come from historic emissions, so they are effectively already locked in. It’s a significant limitation: the tradeoff between transition costs and climate impacts is one of the most crucial questions that long-term scenarios must explore.
Short-term climate scenarios are a valuable new tool for informed financial decision-making, but they have some limitations and should not be used in isolation. We need a toolkit approach to risk and opportunity analysis! That brings us to the next topic in this series: embracing qualitative data about the transition. I’ll cover that in a future post.
Have you used the new NGFS scenarios since their release? What has your experience been in terms of usability and relevance?
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