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Central bankers are more like David Cronenberg than Steven Soderbergh — they don’t hop around between genres trying to create a quirky feel-good experience, they just stick to what they know and hit you with repeated waves of existential horror. The latest summer blockbuster from the ECB Blog is a perfect example — if you take a minute to think about what it’s saying, it will chill your spine.
Here’s the jump scare to end them all:
That orange line is a climate risk scenario, indicating a recession which would be roughly twice as bad as the euro crisis, in line with the peak-to-trough in 2008-9 and only exceeded by the COVID-19 shock. It’s taken from the “Disasters and Policy Stagnation” global scenario of the Network for Greening the Financial System, which in aggregate is even scarier:
Where does the scenario come from? Well, it’s not just the normal “pick a number” exercise that you expect from central bank stress tests. The NGFS maintains three models — a sectoral Computable General Equilibrium one called GEM-E3, a global macro-financial Stock Flow Consistent one called EIRIN and a credit risk model called CLIMACRED. They link up as shown in the diagram below, and between them, they model the effect of shocks on output, the effect on company insolvencies, and the effect of all these factors on global macro variables.
What does any of this mean? Let’s oversimplify:
As you can see from the diagram above, the important bit is GEM-E3. For the technical phrase “Computable General Equilibrium”, mentally substitute “a spreadsheet full of supply chains”. That’s not right, but it captures the important intuition — the purpose of GEM-E3 is that it models the way that the different economic sectors feed in to one another, and how a shock to one percolates through the economy. Because the way that shocks percolate through the economy is partly driven by bankruptcies and partly by financial markets, it needs EIRIN and CLIMACRED to supplement the direct input/output relationships.
The model deals with two kinds of shocks — “transition risk”, where sectors and firms have to change their output plans because of carbon pricing and emissions regulations in order to meet the Paris 2050 targets. And “physical risk”, where sectors and firms have to change their output plans because they are on fire or under water.
Here’s the really scary thing — the “Disasters and Policy Stagnation” scenario shown above is a purely physical risk scenario. And it’s calibrated to large but certainly not impossible shocks — basically a year of twice-a century droughts and wildfires in 2026, followed by a year of twice-in-a-century storms and floods. If you follow through the effects through the sectors, taking into account consumer demand and market reactions, then without a major government support programme, we would be looking at a 5 per cent recession in Europe and North America, more than that in Asia and much more in emerging markets.
Furthermore, look at the dates on the horizontal axis, and consider that the title of the blog post is “No longer the tragedy of the horizon”. The NGFS technical manual makes it clear that there is no feedback from policy or emissions forecasts into the physical risk scenarios — this is the 1 per cent tail risk right now, and there’s nothing that can be done to stop the fire and flood if it happens.
It’s not a puzzle why the ECB is publishing these apocalyptic scenarios — they want the banking industry to be prepared for them too; to have up-to-date flood risk maps and to set aside more capital against loans to borrowers that are particularly vulnerable to weather-based interruption. It’s more of a puzzle why the Federal Reserve and other US regulators decided to leave the NGFS at the start of the year. Even if their climate risk policy is “Don’t Look Up”, they might find that even if you ignore the fire and floods, they may not ignore you.
