Avoiding the Peril of Divergent Net Zero

By Dr. Eman Tabet, Research Associate, RFI Foundation

Emerging market financial institutions considering financial risks related to climate change will benefit from some harmonization of climate scenarios. However, many are more susceptible to physical risks and specific types of transition risk. It is important that the scenarios used for climate risk-related assessment and response are relevant to emerging markets and do not contribute to unevenly shifting transition risk from developed to emerging markets.

  • Climate models used to create climate scenarios by organizations such as the NGFS all have limitations due to the simplifying assumptions they need to be operable
  • Models are used to build scenarios that financial institutions, regulators, investors and other stakeholders can use to look at potential financial impacts of climate change
  • Excluding ‘Divergent Net Zero’ scenarios from the widely used scenarios has implications that affect how transition risk burdens will be shared, which is especially important for emerging markets

As COP27 approaches, discussions are likely to intensify about the varied macroeconomic physical and transition risks that economies face in bringing their emissions trajectories in line with a Net Zero pathway. A paper was published last month highlighting some analytical features including limitations of the various climate-mitigation scenarios developed by the Network for Greening the Financial System (NGFS). One under-discussed concern is the shortage of focus placed on what NGFS labels ‘Divergent Net Zero’.

To give some context, the paper specifically focuses on NGFS’s Integrated Assessment Models (IAMs), which have been the workhorse models used to produce emission-reduction pathways. These pathways incorporate the physical and transition risks resulting from five key drivers based on scenario-specific narratives:

  1. Level of policy ambition (and resulting physical risk)
  2. Timing of policy response
  3. Level of policy coordination
  4. Pace of technological change
  5. Availability of carbon sequestration

The NGFS’s models are used to divine the implications of accepting varying levels of physical and transition risks that inform the scenario-specific narratives when applied to different countries. The different outputs of the models stem from the varying underlying assumptions used, each of which feeds into the scenarios used by multiple stakeholders including regulators, financial institutions and investors to extrapolate what type of economic conditions they will have to navigate in the future.

One of the challenges facing these stakeholders is that they lack consistency in the scenarios used today, and developing baseline scenarios, as the NGFS has done, provides greater uniformity for some defined ranges of scenarios and assumptions. This process is accompanied by some challenges that are built into the models themselves. While IAMs are useful for assessing macroeconomic climate policy, they do face some limitations that affect the accuracy and comparability of the scenarios, especially for the financial sector.

First, there are several possibilities that aren’t considered by the NGFS framework such as geopolitical and socioeconomic uncertainties that are increasingly perceived as important, if difficult to forecast, and particularly of recent significance in the light of COVID and the global energy crisis.

Secondly, the Socioeconomic Shared Pathways used within the models don’t consider the impact of finance despite the major mediating role that financial markets play in mitigating — or exacerbating — climate risks. The financial sector’s role in climate change has been evolving rapidly in recent years, but its responsibility for enhancing access to capital is valuable for influencing the world’s realized climate pathway by making investments that ease climate mitigation and adaptation for firms, especially in emerging markets. The absence of finance in IAMs creates a limitation on their relevance to inform policy and investment decisions, which could result in more delay or a more disorderly transition, producing unnecessary, negative economic costs.

Thirdly, the NGFS scenarios do not incorporate acute physical risks within the economic projections, and only estimate the impacts of floods and cyclones. These are no doubt important risks, and the process of modeling physical risks is difficult. However, other physical risks will materialize, such as wildfires and drought, and this could cause economic recessions not captured in current models.

The risk-assessment situation for climate-related financial risks is at a crossroads. There is a need for standardization of assumptions and narrowing common climate scenarios for use in risk assessment and supervision when assessing macroeconomic climate risks. On the other hand, the heterogenous and multifaceted nature of climate risks, on global and national levels, poses a great challenge to create harmonized models that reflect likely real-world outcomes in diverse geographies and economies.

For emerging markets, the risk is more acute because climate-related physical risks are potentially more severe, and the costs of delay, as well as action, are more of a barrier if the tools developed are not readily accessible. As an example, the scenarios discussed in the NGFS include orderly and disorderly scenarios, although most users of the scenarios compare only between orderly and delayed transition against no action (‘Hot House World’). However, one of the disorderly scenarios that NGFS considers is the Divergent Net Zero outcome, where each country does it alone in an uncoordinated way, focusing on different sectors with different implied carbon pricing.

One implication of the exclusion of a divergent net-zero disorderly scenario in most practical uses of climate scenario analysis, despite being prepared by the NGFS, is that it carries much more significant economic risks for many emerging markets, particularly those with significant reliance on fossil fuel exports. For these economies, transitioning to low carbon is going to appear costly in the various ‘orderly’ scenarios considered, but the cost of inaction is only widely considered in a ‘Hot House World’ scenario, for which there is more modest impacts than in a divergent Net Zero scenario.

Even if current fossil fuel exporters develop strong-enough climate policies to reach their own Net Zero targets, they could face much higher climate-related risks so long as there is no effective coordination of the transition on a global level. Without it, the inconsistent carbon pricing (explicit or implied by policies to limit emissions) across sectors will impose substantially higher transition costs compared to the orderly (prompt or delayed) transition scenarios.

When analyzing the climate finance landscape among emerging markets, RFI’s research has highlighted the lack of coordination, and contradictions as a common occurance, even within some countries’ own climate-related policies. Just as there needs to be an emphasis on coordination at country levels, considerations of transition-related risks should also consider how to avoid negative ramifications of the lack of global coordination, and reduce the transition costs towards Net Zero.

The way the Paris Agreement is designed, each country is able to set targets and climate policies independently of all the others, with international coordination guided by the sum of the policies. Just as has been noted with the IAMs that underpin global climate scenarios, this top-down view smooths out the national and regional discrepancies as an input into scenarios that broadly focus on stylized orderly transitions varying primarily the pace of change. However, country-level decisions do have potentially detrimental impact through the spillover effects of climate policies across countries that could create a divergent Net Zero with the costs of transition unevenly shared.

As developed markets transition within the outlines of their climate targets, and the resources they enjoy — including stronger insurance markets, which allows them to mitigate some of the shocks — this may lead to greater unevenness of the transition risks falling on emerging markets. Combined with similar patterns of physical risk, which also fall disproportionately on emerging markets, there is a need to revisit the ‘standard’ scenarios used by the financial sector.

It is not effective to just critique the models that have been developed, which are widely acknowledged to be stepping-stones to help speed up the transition. In evaluating the balance between ‘standardized’ and ‘realistic’ models, one important consideration should be ensuring that the financial sector and regulators can evaluate decision-making on climate risks. This must recognize the endogeneity of the financial sector’s actions so that it will contribute to dampening, rather than accentuating, the disparity between realized transition risk and the degree of responsibility for the emissions that will enter the atmosphere before the world reaches Net Zero.

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Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.

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Blake Goud

Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.