New NGFS scenarios

NGFS releases updated and improved climate scenarios

On 6 September the Network for Greening the Financial Sector (NGFS) released the third vintage of its climate scenarios. This new version includes updates on GDP and population pathways as well as the most recent climate commitments made at UN Climate Conference (COP26) in November 2021. For the first time the scenarios include projections of the potential losses from extreme weather events (acute physical risk, in particular cyclones and river floods) to complement the chronic physical risk (trend changes in agricultural and labour productivity due to temperature change) impacts on the macroeconomy that were already included in the previous version. The scenarios also include the latest trends in renewable energy technologies and key mitigation technologies. Moreover transition risks are represented with increased granularity in certain sectors. The scenarios do not yet account for the impact of the war in Ukraine.

NGFS scenarios in short

The NGFS scenarios have been developed to provide a common starting point for analysing climate risks to the economy and financial system. The NGFS has six scenarios in three categories: orderly, disorderly and hot house world. Orderly scenarios assume climate policies are introduced early and become gradually more stringent. In the orderly scenarios, both physical risks (chronic impact on productivity, acute impacts from extreme weather events) and transition risks (as result of policy and regulation, technology development and consumer preferences) are relatively subdued. Disorderly scenarios assume higher transition risk due to policies being delayed or divergent across countries and sectors. Hot house world scenarios assume some climate policies are implemented in some jurisdictions, but globally efforts are insufficient to halt significant global warming. The scenarios result in severe physical risk including irreversible impacts like sea-level rise.

A key indicator of the level of transition risk is the shadow emissions price, a proxy for government policy intensity and changes in technology and consumer preferences. This shadow price is a measure of overall policy intensity. Governments are pursuing a range of fiscal and regulatory policies, which have varying costs and benefits.

Results show that immediate action is the least costly in the long run

Reaching global net zero CO2 emissions by 2050 will require an ambitious transition across all sectors of the economy. The climate scenarios continue to show that immediate coordinated transition will be less costly than inaction or disorderly transition in the long run. For the world economy, the net-zero scenario is shown to have a moderately negative impact on world GDP compared to baseline. Stringent mitigation in line with the net-zero 2050 scenario will already be beneficial by 2050 and strongly reduces risks towards the end of the century.

GDP impacts from transition risk are more markedly negative in the disorderly scenarios as the speed of the transition combined with investment uncertainty affects consumption and investment. GDP losses from physical risk vary in line with different temperatures projected for each scenario. Physical risk in hot house world scenarios (such as Current Policies) will lead to the strongest negative impact on GDP with economic costs diverging significantly after 2040. For all scenarios and time scales, physical risks outweigh transition risks. GDP losses from physical risk are higher in the third vintage scenarios compared to the second, due to the (high-level) inclusion of acute physical risk for the first time, and an increase in the damage estimates from chronic physical risk. GDP losses from chronic physical risks reach more than 6% in 2050 and up to 18% by the end of the century in the Current Policies scenarios. This damage is concentrated in countries that already have a warmer climate.

In terms of inflation, the implementation of carbon prices in the Delayed Transition scenario tends to raise energy costs in first instance, initially weighing down on prices compared to the baseline (as lower demand and financial market losses hit output). Rising carbon prices subsequently feed through to modest increases in inflation and unemployment before returning to prior trends. In the net-zero scenario for Europe and China inflation tends to first rise and then decline compared to the baseline. In the Current Policy scenario inflation tends to rise at a very modest pace.

Using carbon revenues for government investment works best to mitigate GDP impact of carbon price

In the new scenarios, an important issue is taken into account more explicitly: namely the use of carbon revenues. In a climate scenario, the impact of the carbon price itself is modelled via different channels, with the price channel being the most obvious one. However, when a carbon price is implemented, carbon revenues flow to (usually) government coffers. These revenues than have a separate impact on the economy, depending on how they are used. The carbon revenues can, for instance, be used to pay down government debt, with the result being lower government debt but no direct effect on economic activity. The revenues can also be used to lower taxes to the private sector generally, or to support to households specifically. Lastly, the revenues can be turned into government investment in for instance the energy transition.

The NGFS explores these different options in a sensitivity analysis for the net-zero scenario. Their findings show that the carbon price impact (the combined effect of the “carbon price increase channel” and the “use of carbon revenues channel”) triggers a decrease in GDP and an increase in inflation in the short term. Different ways of carbon recycling lead to (limited) differences in economic outcomes. The analysis shows that a full recycling through public investment leads to the most beneficial effects on GDP. The effects are different per country, which can be explained by among others the degree of energy intensity or different carbon price levels. For the US, the GDP impact becomes positive around 2040 in the “recycling through government investment” option, while the other options cannot fully absorb the negative shock coming from higher carbon prices. For Germany the GDP impact is less and becomes positive in 4-5 years in the public investment recycling scenario.

The inflationary impact of the public investment recycling option is also the strongest, with a 4% increase of US inflation from baseline. In all cases, however, inflation returns to baseline within a 5-year period following the carbon price increase. This is among others due to an increase in policy interest rates. All the options lead to higher interest rates, with the effect again the largest when recycling is done through government investment. If recycling is done through paying down government debt, interest rates return to baseline quickly (after 5 years), while the other options have monetary policy tighter for longer.

This article is part of the Sustainaweekly of 19 September 2022