Toward a Framework for Assessing and Using Current Climate Risk Scenarios Within Financial Decisions

46 Pages Posted: 10 Apr 2023 Last revised: 25 Apr 2023

See all articles by Moritz Baer

Moritz Baer

University of Oxford - Smith School of Enterprise and the Environment; University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; UK Centre for Greening Finance and Investment (CGFI)

Matteo Gasparini

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; University of Oxford, Smith School of Enterprise and the Environment

Ryan Lancaster

UK Centre for Greening Finance and Investment

Nicola Ranger

World Bank

Date Written: March 27, 2023

Abstract

In response to a growing awareness of the potential impact of climate change on financial stability, academics, financial institutions (FIs), central banks and supervisors (CB&S) have developed a suite of scenarios and analytical tools to assess forward-looking climate-related financial risks, inform macro-prudential policies, counterparty risk management and business planning decisions. Climate scenario analysis brings new challenges versus traditional scenario analysis by FIs, particularly given the limitations, uncertainties, and trade-offs inherent in the data, models, and methods for such climate financial risk assessments. We argue that all scenarios are wrong, but this does not necessarily mean that they cannot be useful if used and expanded upon with full awareness of the limitations. In this paper, we analyse those limitations in the context of the specific requirements by FIs for scenario analysis and propose an approach to scenario construction and expansion to complement existing scenarios and increase their suitability for decision making for key financial use cases. Importantly, we argue that current scenarios are likely closer to the lower end of the range of plausible future risk for both physical and transition risk. This has implications for both stress testing and risk management, and business planning. We advocate for harnessing the full breadth of scenario narratives to avoid the accumulation of systemic risks and our framework provides an initial step toward this. Finally, we call for FIs, CB&S and research institutions to work closely together to develop a more comprehensive scenario taxonomy to help navigate the implications of material financial risk under uncertainty.

Keywords: climate change, stress testing, risk management, sustainable finance; financial supervision; scenario analysis, financial risk

JEL Classification: Q51, Q43, G21, G32

Suggested Citation

Baer, Moritz and Gasparini, Matteo and Lancaster, Ryan and Ranger, Nicola, Toward a Framework for Assessing and Using Current Climate Risk Scenarios Within Financial Decisions (March 27, 2023). Available at SSRN: https://ssrn.com/abstract=4401026 or http://dx.doi.org/10.2139/ssrn.4401026

Moritz Baer (Contact Author)

University of Oxford - Smith School of Enterprise and the Environment ( email )

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

UK Centre for Greening Finance and Investment (CGFI)

United Kingdom

Matteo Gasparini

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Manor Road Building
Oxford, OX1 3UQ
United Kingdom

University of Oxford, Smith School of Enterprise and the Environment ( email )

Ryan Lancaster

UK Centre for Greening Finance and Investment

Nicola Ranger

World Bank

1818 H Street, NW
Washington, DC 20433
United States

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