NGFS Climate Scenarios Sensitivity Analysis to Macroeconomic Policy Assumptions

Introduction to NGFS Climate Scenarios

The Network for Greening the Financial System (NGFS) has developed comprehensive climate scenarios to help central banks, supervisors, and financial institutions assess the potential impacts of climate change on the economy and financial system. These scenarios provide a structured framework for analyzing both the physical risks from climate change and the transition risks associated with the shift to a low-carbon economy.

Climate scenarios are narrative descriptions of how the future might unfold, incorporating assumptions about policy responses, technological developments, and socioeconomic factors. The NGFS scenarios are particularly valuable because they combine these narrative descriptions with quantitative modeling, allowing for a more concrete assessment of potential climate-related financial risks.

The Three NGFS Climate Scenarios

The NGFS has developed three principal climate scenarios:

• Orderly Transition: A scenario where climate policy is introduced early and becomes gradually more stringent, allowing for a smooth transition to a low-carbon economy.
• Disorderly Transition: A scenario where climate policy is introduced late, leading to a rapid and potentially disruptive transition to meet climate goals.
• Hot House World: A scenario where climate policies remain insufficient, leading to increased global warming and severe physical impacts from climate change.

Importance of Sensitivity Analysis

Sensitivity analysis is crucial for understanding the range of possible outcomes under different assumptions. By varying key parameters, analysts can assess how robust their conclusions are and identify which assumptions have the most significant impact on the results. When applied to NGFS climate scenarios, sensitivity analysis helps to:

• Quantify uncertainty in climate-related risk assessments
• Identify which policy choices have the greatest economic impact
• Understand the potential threshold effects and tipping points
• Provide a more comprehensive view of risk management for financial institutions

Macroeconomic Policy Assumptions in Climate Scenarios

Macroeconomic policy assumptions play a critical role in shaping climate scenarios and their outcomes. These assumptions include:

• Fiscal Policy: Government spending, taxation, and subsidies related to climate action
• Monetary Policy: Interest rates and central bank interventions that affect the cost of climate investments
• Regulatory Policy: Carbon pricing mechanisms, emissions standards, and other regulatory measures
• Trade Policy: International agreements, tariffs, and trade measures affecting climate technologies
• Technology Policy: Research and development support, intellectual property frameworks, and technology deployment incentives

Sensitivity Analysis Framework

A robust sensitivity analysis framework for NGFS climate scenarios should consider:

• Parameter Selection: Identifying the most influential macroeconomic policy levers
• Range Definition: Establishing plausible ranges for each parameter
• Model Implementation: Ensuring the climate-economy models can accommodate parameter variations
• Result Interpretation: Deriving meaningful insights from the sensitivity analysis

Impact of Carbon Pricing Variations

Carbon pricing is a central policy instrument in climate scenarios. Sensitivity analysis examining different carbon price trajectories reveals:

• Higher carbon prices accelerate decarbonization but may cause short-term economic disruption
• The pace of carbon price increases affects investment timing in low-carbon technologies
• Carbon price differentials across regions can lead to carbon leakage or competitive advantages
• Revenue recycling methods strongly influence economic outcomes and distributional effects

Monetary Policy Considerations

The interaction between monetary policy and climate scenarios is an emerging area of interest. Sensitivity analysis related to monetary policy assumptions might explore:

• How different interest rate environments affect the economics of climate investments
• Central bank asset allocation strategies and their climate impacts
• Monetary policy responses to climate-induced economic shocks
• Green monetary policy tools and their effectiveness

Monetary Policy Scenario	Impact on Transition	Potential Risks
Traditional monetary framework	Neutral to slightly slowing	Climate risks mispriced in financial markets
Climate-informed monetary policy	Accelerating	Possible central bank mission creep
Green monetary policy tools	Strongly accelerating	Market distortion effectiveness concerns

Fiscal Policy Sensitivity

Government spending and taxation decisions significantly influence climate outcomes. Key areas for sensitivity analysis include:

• Infrastructure Investment: Public spending on climate-resilient infrastructure, renewable energy, and energy efficiency programs
• R&D Support: Government funding for climate technology development and deployment
• Tax Incentives: Tax credits, deductions, or exemptions for low-carbon investments and activities
• Just Transition Measures: Support for workers and communities affected by the phase-out of carbon-intensive industries

Research indicates that well-designed fiscal policies can both mitigate climate change and generate economic benefits, creating synergies that reduce the overall cost of the transition.

Technology Development and Deployment Assumptions

Technological progress is a critical driver of climate outcomes. Sensitivity analysis should explore assumptions about:

• The rate of improvement in renewable energy technologies
• Breakthrough technologies for hard-to-abate sectors
• The cost trajectory of energy storage technologies
• Carbon capture and storage deployment and effectiveness
• Adoption rates for energy efficiency measures across sectors

These factors interact strongly with policy assumptions. For example, more aggressive support for R&D combined with favorable market conditions can accelerate technology deployment, while policy uncertainty may delay investment decisions.

Regional and Sectoral Variations

The sensitivity of outcomes to macroeconomic policy assumptions varies significantly across regions and economic sectors:

• Regional Differences: Developing economies often face different policy trade-offs than developed economies, with greater emphasis on economic growth and development
• Sectoral Sensitivity: Carbon-intensive industries like steel, cement, and chemicals are particularly sensitive to policy assumptions
• Financial System Implications: Banks with exposures to sensitive sectors may face varying levels of risk depending on policy design

Practical Applications for Financial Institutions

For banks, insurers, and asset managers, incorporating sensitivity analysis into climate risk assessment offers several benefits:

• More robust climate stress testing capabilities
• Identification of potential concentrations of climate risk across portfolios
• Enhanced strategic planning under different policy environments
• Better-informed capital allocation decisions
• Improved communication with regulators and stakeholders about climate risk

Methodological Approaches

Several methodological approaches can be employed for sensitivity analysis in NGFS climate scenarios:

• One-at-a-time (OAT) Variations: Changing one parameter while holding others constant
• Monte Carlo Simulations: Simultaneously varying multiple parameters according to probability distributions
• Scenario Discovery: Using data mining techniques to identify combinations of assumptions leading to particular outcomes
• Robust Decision Making: Identifying policies that perform well across a wide range of assumptions

Challenges and Limitations

While sensitivity analysis provides valuable insights, several challenges should be acknowledged:

• The complexity of climate-economy systems makes it difficult to isolate the effects of individual parameters
• Nonlinearities and thresholds can lead to unexpected outcomes
• Parameter interdependencies may be poorly understood
• Technical constraints on model complexity and computation time
• Limited historical data for calibrating extreme climate scenarios

Emerging Research Directions

The field of climate scenario sensitivity analysis is evolving rapidly. Emerging research areas include:

• Integrating political economy models to better capture the feasibility of different policy paths
• Incorporating behavioral insights to understand how firms and households respond to policy signals
• Developing more sophisticated representations of financial system feedbacks
• Linking macroeconomic models with sectoral and firm-level analysis
• Exploring the implications of different policy mixes and sequencing

Conclusion

Sensitivity analysis of NGFS climate scenarios to macroeconomic policy assumptions provides crucial insights into the range of possible climate outcomes and the associated economic impacts. By systematically varying key parameters, analysts can better understand the uncertainties inherent in climate projections and identify robust strategies for managing climate-related risks.

As climate-related financial risks become increasingly prominent, the ability to assess sensitivity to different policy paths will be an essential tool for financial institutions, regulators, and policymakers. The NGFS climate scenarios provide a valuable foundation for this analysis, but their utility is enhanced when combined with comprehensive sensitivity testing that recognizes the complex interplay between climate outcomes, economic responses, and policy choices.

Ultimately, this knowledge can support more informed decision-making, helping to align financial flows with climate objectives while safeguarding financial stability in the transition to a net-zero economy.