Scenario Analysis and the Economic and Financial Risks from Climate Change

Setting environmental policy is the job of governments. But climate change can affect the ability of central banks to achieve their goals for financial stability and inflation targeting. Two sets of risks are of particular concern:

  • Physical risks from more frequent and severe extreme weather events. These can cause economic disruptions and losses to the financial system.
  • Transition risks from the move toward a lower-carbon economy. Sudden or unexpected changes in consumer and investor preferences or in government policies that make pollution more expensive could raise financial system risks.

In response, central banks are stepping up efforts to assess climate-related risks. The current suite of central bank economic models, however, do not incorporate climate-change effects. Uncertainty over future developments related to climate change also makes assessing these risks challenging. These developments include policy developments, technological developments and changes in the natural environment.

Some central banks and private financial institutions are developing tools to carry out climate-related scenario analysis. Scenario analysis examines different plausible future states of the world. It forecasts a set of situations that could happen rather than predicts what will happen. It can help users evaluate a range of hypothetical outcomes based on different assumptions of what may occur. Scenario analysis is particularly useful for climate change, where the evolution of key variables is uncertain. To be the most useful, these scenarios should be extreme yet plausible. This will give a sense of the full range of possible risks.

Scenario analysis in this study

This paper adapts climate-economy models that have been applied in other contexts for use in climate-related scenario analysis. We consider illustrative scenarios for the global economy that could generate economic and financial risks (Table 1). We do this by varying assumptions on key variables such as climate policy in plausible ways. We then use a computable general equilibrium (CGE) model—the MIT Economic Projection and Policy Analysis (EPPA) model—to assess the economic impacts of these scenarios; this also provides insights into potential financial system risks. We use the results from both a Dynamic Integrated Economy Climate (DICE) model (an integrated assessment model) and the broader literature to inform physical risks.

Table 1: Overview of scenarios

Scenario Description
Business as usual No further action is taken to limit global warming. Rising emissions cause a substantial rise in average global temperatures.
Nationally determined contributions (NDCs) Beginning in 2020, countries act according to their pledges under the Paris Agreement. They reduce global warming, but their actions are not enough to limit warming to an additional 2°C above pre-industrial levels by 2100.
2°C (consistent) Countries act to limit global warming to 2°C by 2100.
2°C (delayed action) Countries act to limit global warming to 2°C by 2100, but the action does not begin until 2030.

Our illustrative results suggest there are significant economic risks from climate change and the move to a low-carbon economy. The impacts and risks vary across the different scenarios (Figure 1). The results suggest that while transition risks can be avoided through inaction, this comes at a significant economic cost through a greater amount of physical damages. Action that comes late must be more abrupt to keep temperature increases in check, which raises transition risks. Earlier action also allows more time for new technologies to enter the market in response to price signals. These new technologies lead to a larger green energy sector and lower transition costs.

Figure 1: Illustrative scenarios show a range of physical and transition risks

Figure 1 depicts a relative ranking of scenarios along two risk dimensions: physical risks from more frequent and severe weather events, and transition risks from the move toward a lower-carbon economy. The illustrative scenarios suggest some trade-offs between physical and transition risks.

It is worth noting that this study does not provide a cost-benefit analysis of specific climate-change policies. Policies to prevent global warming—such as carbon taxes, emissions caps and spending on technological development—fall outside the mandates of central banks. Assessing these policies would require a different modelling framework as well as a broader set of considerations that are beyond the scope of the Bank of Canada.

Future work

The Bank of Canada is an active member of the Network for Greening the Financial System (NGFS). The NGFS is a group of central banks and financial institution supervisors who share best practices and contribute to the development of climate risk management. As part of this work, the NGFS is developing an analytical framework for assessing climate-related risks. Scenario analysis will play a key role in this effort. The NGFS is developing a standard set of climate-related scenarios for analysis by central banks and others. The Bank of Canada is actively contributing to this work and will use it and our own internal modelling in developing Canada-specific scenario analysis to inform monetary policy and assess financial system risks.