The author is a professor of environmental studies at the University of Colorado
The late Kenneth Arrow, who won the 1972 Nobel Prize in economics, once worked as a long range weather forecaster in the US military. When he realised that these weather forecasts were no more accurate than random guesses, Arrow conveyed the message to his superiors. “The commanding general is well aware that the forecasts are no good,” Arrow was told. “However, he needs them for planning purposes.”
Somewhat like Arrow’s commanding general, the European Central Bank is currently conducting an economy-wide climate stress test. This makes good sense because climate change is real and serious. The ECB test, which aims to assess “the exposure of euro area banks to future climate risks . . . under various climate scenarios”, is also ambitious and wide-ranging. As ECB vice-president Luis de Guindos wrote in March, it projects 30 years into the future and covers around 4m companies worldwide and 2,000 banks — “almost all monetary financial institutions in the euro area”.
Unfortunately, the scenarios the ECB are relying on are obsolete, calling into question the whole exercise. Although somewhat technical, come down the rabbit hole with me on this one because things soon get interesting.
The ECB and over 60 other central banks belong to the Network for Greening the Financial System. This voluntary group covers most of the global economy and advocates climate stress testing to assess financial resilience “to hypothetical, extreme, yet plausible scenarios”. Yet these scenarios come with a health warning, namely: that the most commonly used ones “were designed about 10 years ago and do not match well with recent emissions trends”.
In fact, as I and my colleagues have documented, these scenarios have significantly over-projected carbon dioxide emissions since 2005. Moreover, even the NGFS’s newer scenarios are out of step with real-world data. This could lead to poor decisions and possibly even higher systemic risks.
The NGFS uses three broad scenarios to guide climate assessments. “Orderly” assumes policy change starts now, leading to net-zero emissions by 2070. “Disorderly” assumes climate policies are delayed until 2030, requiring a quicker move to net-zero, by about 2050. “Hothouse world” assumes no change, with emissions growing to 2100 and severe environmental consequences.
The NGFS is clear that trade-offs are required to curb emissions. A carbon tax might speed the move to net zero and help foster carbon capture technologies. At the same time, though, it would increase the costs of certain raw materials and require businesses to overhaul their operations. That might lead to lower short term growth but far higher long term growth — the opposite of the hothouse scenario.
Regrettably, though, some of the other assumptions underpinning the three NGFS scenarios are implausible.
For instance, they assume global carbon dioxide emissions from fossil fuels in 2020 of about 36 gigatonnes. Yet, in 2020, these emissions were closer to 33 Gt, a gap only partly due to the dire economic consequences of the pandemic. By 2040, this small error grows very large. The “hothouse” scenario projected about 45 Gt of fossil fuel emissions. Yet, even before the commitments made at last month’s climate summit, the International Energy Agency projects about 35 Gt of emissions in 2040. The gap widens the further into the future you go. According to a recent analysis in Nature, fossil fuel emissions would be about 25 Gt by 2100, under assumed 2019 policies and technologies. Yet the hothouse scenario projects 81 Gt, over three times as much.
Stress testing uses “hypothetical, extreme” scenarios and, as the NGFS makes plain, these must be “plausible”. Yet it is simply unconvincing that the world will collectively decide to convert much of its energy supply to coal, which is what it would take for fossil fuel emissions to exceed 80 Gt by 2100.
The ECB uses its climate scenarios much as Arrow’s general used his “no good” weather forecasts — because there are no alternatives for planning purposes. Even so, there is an urgent need to take stock. Because these climate scenarios are typically out of sight and technical, those who rely on them may be unaware how they have diverged from the real world. Because they are institutionalised, changing these stress tests will also be hard.
Still, if financial institutions are to run meaningful climate stress tests, it is imperative that they be based on the latest science and not on improbable scenarios.