Using Energy-Economic Models for Climate-Related Financial Impact Analysis - MATLAB
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      Using Energy-Economic Models for Climate-Related Financial Impact Analysis

      Sergey Paltsev, MIT

      Climate change poses financial risks that arise from shifts in the political, technological, social, and economic landscape that are likely to occur during the transition to a low-carbon economy. One of the global community’s most significant contemporary challenges is the need to satisfy growing energy and food demand while simultaneously achieving very significant reductions in the greenhouse gas emissions and sustainable development. In pursuing this goal, decision makers need to make strategic choices that address both physical risks (damage from extreme events such as fires, floods, droughts, and sea-level rise) and transition risks (financially consequential shifts in political, technological, social, and economic landscapes in the transition to a low‑carbon future). Energy-economic models can be used to support decision makers in quantifying these risks by integrating across systems, sectors, and scales. Learn about a framework for addressing climate-related financial risks where scenario analysis plays a key role in climate risk management.

      Published: 5 Oct 2021

      Hello. I'm Sergey Paltsev, Deputy Director of the MIT Joint Program on the Science and Policy of Global Change and Senior Research Scientist at MIT Energy Initiative. It is my extreme pleasure to participate in Matlab Computational Finance Conference and present some of our research activities related to using energy economic models for climate-related financial impact analysis.

      First of all, let me start with a bigger picture. Many world regions face increasing pressures from global and regional changes in climate. But that's not the only impacts which we need to take into consideration when we are trying to analyze those risks because, at the same time, we also face population growth, urban area expansion, and other impacts from social, economic, and environmental development. And climate change makes these things worse. So climate change imposes physical and transition risks that affect all sectors of economic activity.

      So how do we address those climate risks? How do we quantify those climate risks? At MIT, we have several entities which tries to understand what are the pathways for decarbonizing our economy. What I'm going to present is activities at the MIT Joint Program which we have been doing for the last 30 years. The program was organized in 1991. And since then, we realized that we need to organize it as a team of natural scientists and policy analysts.

      And we have a lot of interaction with decision-makers. We are interacting with industry, we're interacting with governments, with non-governmental organizations. And we really hope that we will see the world where industry leaders are going to make environmentally and economically sound choices. And that's exactly what we are trying to help. That's what we are trying to develop with our tools and our expertise, and work with those decision-makers.

      So let me turn back to climate-related risks. Usually they are divided into two parts. Some of them are related to physical risks. Those are the risks which are brought by changes in the climate system in the Earth response. So those are related to increase in flooding, droughts, sea level rise, heat stresses, and other negative impacts. And we see that we are having more and more of these extreme events.

      On the other side, we also need to take into consideration transition risks. So those are the risks which are related to changes in political, economic, technological, and societal ways of dealing with these transition pathways or not transitioning fast enough. Because it really matters who occupies the White House. It really matters what kind of advances in the technology we are making because it really matters if solar and wind energy becoming competitive with coal power with natural gas because that is going to ease the pace of the transition.

      It really matters what kind of economy do we have. So is it fragile after the COVID pandemic, or strong enough to incorporate very aggressive actions for emission mitigation? And it's very important what kind of pressure from the society we have and we will have into the future because companies and policymakers do respond to actions by shareholders, financial community, and the society. And all that is going to impose risks for companies, both on the physical side and on transition side.

      Another point which I'm trying to bring to your attention is that sometimes the challenges are a little bit oversimplified. So you can hear a lot that, well, if we are going to switch to wind and solar, that is going to solve all the issues. Unfortunately, the challenge is more difficult than that. So these diagrams from the IPCC assessment report, 5 shows that if you decarbonize all electricity and heat production globally-- so those are global diagrams-- you are going to eliminate only a quarter of the emissions-- so only 5%. So we need to do much more than that.

      And the solutions, for example, for industry, or for agriculture, or for buildings might be very different in comparison to those which we can employ in electricity, heat production, or transportation if we are going to, for example, electrify a light duty and also reduce emissions from heavy duty vehicles. It's also not only about the carbon dioxide, but also other the gases are extremely important. And you heard these goals of the net zero emissions. That means all of these emissions which you see on these diagrams have to be eliminated.

      There are numerous impacts which any company is going to have based on this transition to a low carbon society. I've listed only some of them here. And definitely, I'm not going to have time to go into the detail to many of these. And I can list probably, in addition to these, similar type of other input parameters.

      And what's important is that every company is going to get those impacts at different scales. And those relative impacts need to be quantified. So we need to quantify those climate-related financial risks because if they are not quantified, if they are not priced, if they are not taken into the decision-making, well, then we are not prepared. That's exactly what we are trying to do to quantify those risks.

      So how to quantify those risks? Well, the best way what we know now is scenario analysis. . In other words, we are not going to predict the future, but we are going to make projections and try to understand what are the options-- how your resilience, how your risks are going to be changing in these different scenarios. And one example which is related to financial risk scenario analysis is our joint research with Bank of Canada.

      So this particular paper is publicly available at the Bank of Canada website where they have explored several scenarios from our energy economic model, which is called the EPPA model-- which stands for Economic Projections and Policy Analysis-- where they try to understand different scenarios and try to see what we can say in terms of the economic and financial risk. That was the initial step of exploration of this particular topic, where we were trying to see how the financial system might be impacted.

      Well, currently, we are doing the expansion of that project with the Bank of Canada. And hopefully that report is going to be released at the end of the year, where we expanded the scenario set and we look at multiple regions and multiple sectors. And we are trying to understand several dimensions how different companies or different industries might be affected on that.

      So I've listed a couple of the illustrative examples, what we are looking in these scenarios. And this is further going to be converted into value at risk, which is something which every industry, every company, every financial institution would need to understand how robust they are in relating to climate-related financial risks.

      Here, I'm listing some other examples of application of our tools and expertise to this topic. A couple of years ago, we have done a study on how to do financial disclosures and how to use scenarios for financial disclosures, where we work with some financial firms and some energy firms in order to understand the best practices. So that's another report which is publicly available. And if you cannot find it on the MIT website, please contact me. I'll be more than happy to share that.

      We also used our scenarios for assessing transition risk-- so in line to that work with Bank of Canada, which we are currently doing. And our current project, we are working with Morgan Stanley Investment Management where they use our carbon price projections to look at long-term profit margins for individual companies and for stock returns.

      And so this is a very active area currently. And hopefully we will be also working with MathWorks and try to expand our joint approach, where we are providing our projections at the level of the industry, at the level of the region. And then it can be unpacked into the impacts on the individual industries and individual companies.

      How do we do that? So we have the suite of models which we have developed over time which we apply both for transition risks and financial risks. And those models are providing the integrated picture of the economy in different regions, in different sectors, in different pathways for international trade. So we are tracing all the trade between different regions of the world. And we also assess both transition impacts of different policy, but also the physical impacts. In my presentation here, I wouldn't have time to go into detail into all the physical aspects of our analysis.

      And if you are interested, well, I welcome you to go to our website and learn more about our tools and about our current activity in this area. So it's a lot of interaction between different systems and different scales because, if you are trying to understand the risks to your particular company, even though you might be in a particular industry, you're going to be affected by many other actors and economic agents in different parts of the world.

      Here I'm showing you a couple of the examples-- again, mostly on the economic side and the policy side-- of our recent publications. So, all those publications in the peer-reviewed literature. And you can see from this list that we are addressing many different issues which are related to transition to low carbon economy. So we are looking at geopolitics, we're looking at the health effects, we are looking at distributional impacts, we are looking at decarbonizing both power generation but also industry.

      And I want to bring your attention to our global change outlook. So this is another publicly available information on our website. You're welcome to try and see what is our current view where the world is going and where we would want to go.

      What I'm presenting here is our dashboard-- our visualization tool. Again, it's publicly available on our website. Please go and explore different outputs from our modeling, which we report in visualization tool. And we also provide three Excel files for different scenarios which we have considered in the outlook. And you can explore issues which are related to energy and economics, but also to emission and climate.

      And one thing which I put on this particular slide, that we are actually currently not consistent with the paths we just specified in the Paris Agreement. So, unless much more dramatic action in terms of the emission reduction is going to be employed, we are going to pass those thresholds. So it means that, while we still need to understand better how to quantify those risks which are related to not so fast transition, and also the physical impacts which we are likely to face more and more often.

      We also provide different information on different aspects of the economy. So here, for example, I'm showing you the global primary energy. And we have all that information for 18 regions of our model which is, again, available on our website. So you can see that we've accelerated actions. We are decarbonizing much faster. But by 2050, we don't really envision that we will be really at net zero. So, much more action is needed if that goal is going to be reached.

      Similarly, this diagram is providing you the information about the global electricity system. And you see those green bars on the top, and it means that we indeed are projecting more and more wind and solar. But remember that slide at the beginning which I provided you which tells you that, well, that's only part of the story.

      So that's a great progress, that's a movement in the right direction, but much more is needed. And again, as a company, you need to make sure that you are calculating those risks which are related not only to technology, but also to what kind of policy and what the magnitude of policies are going to be implemented.

      So as an example, the US recently announced the reduction 50% to 52% in 2030 relative to 2005. And also, the US administration announced the goal of 50% electric vehicles share being sold by 2030. So all these announcements, all these policies need to be taken into account and try to understand how exactly your particular industry might be affected by reaching this target or not reaching these targets.

      Another calculation which we have done in the outlook is the value at risk. So most of the companies, obviously, which are going to be affected are related to fossil fuel production because any decarbonization strategy most likely is going to affect the amount of the demand for fossil fuels. Again, carbon capture, which we are trying to analyze quite in depth in different applications-- in power generation, industry, in biomass, with carbon capture-- may affect those pathways and may affect the life of the assets.

      But the calculation which we have done here illustrates that, in principle, we might have a lot of implication. And so, in the calculation which we have done where we compare the value of earnings from those fossil fuels between two different scenarios, we arrived at a quite large number-- $17 trillion in stranded assets. So that's actually more than the current GDP of China. It's slightly less than the US GDP. So that tells you that it's a lot of money at stake, and we need to understand those risks.

      Also pain to make sure that you understand what kind of the scenario analysis, what is the actionable information. Because the forward-looking behavior by those asset owners is going to reduce losses. It's going to reduce where we are going to be. And so you have to be also realizing how to use these scenarios. And that's exactly what we are helping companies, is interpretation and unpacking these scenarios.

      So what is the advantage of our tools which we have developed at the MIT Joint Program? We have been long advocates in trying to represent uncertainty. So not just one scenario, but multiple scenarios. So what we do, we are doing the ensembles. So usually, we do 400 ensembles.

      And so, in the ensemble, we are doing the special technique for sampling of the input parameters where we have varying input distribution function. And we are doing that both on the socioeconomic side, but also on the climate side. And that allows us to make these probabilistic statements, not just providing you one number and one scenario, but also assess the probabilities in terms of probabilities of reaching a particular target, a particular cost. And so that is really important to make sure that we are doing this risk quantification where we can understand both physical side and transition side.

      So just to reiterate, what are the advantages of our approach? How are we addressing those climate related financial risks? In our tools, we are actually integrating both of them. So it's not just physical, or just transition. The tool is integrated and provides a consistent picture. We are mapping scenarios to economic sectors.

      So those of you who are familiar with the assessment reports from IPCC and other exercises, usually you know that those scenarios are quite aggregated, and usually they don't really provide you the granularity at the level of the economic sectors. This is exactly where we provide the value added in order to understand what are the impacts. We are downscaling those transition pathways to particular countries. And it's a consistent representation of both human and climate pathways because they are integrated and they are interrelated.

      Another point to make is that, if you are talking about the assessing risk, you need to quantify risk. You need to quantify the uncertainty. And that's exactly what we are doing. That's exactly our approach with our tools.

      And currently, we are expanding quite dramatically into identifying physical risks. I wouldn't have time to go into much detail into there. Again, I advertise our website. Please visit us at globalchange.mit.edu. And you will see that we are adding a lot in our multisystem dynamics where currently we are focusing on the United States where we are trying to address the different types of the risks and how they combine together. What are the tipping points when you combine those different risks? So I welcome you to look at that work which we are doing.

      So to summarize, as I have mentioned, we need to eliminate all emissions. So zero means zero. So it's not just one particular sector, or one particular country, or one particular gas. We need to address all of them. And there are several challenges and several opportunities, several dimensions which we need to work. So I've listed a couple of the big questions here.

      And there are many, many, many, many other questions which we are trying to understand, both on the economic side, on geopolitical side, which is also quite important because of the powers in the world are changing-- so from those who are fossil fuel exporters to those who has access to critical materials which are needed for decarbonization. And also, the environmental challenges which are related to this transition.

      I want to finish with these greenhouse gamble wheels. So that's the approach which we have been developing for quite a while. And what we are trying to represent here, we are trying to communicate that it's not just one number. Again coming back to that notion of uncertainty, notion of quantifying risk. We need to understand that, well, most likely it's not just one pathway where you are trying to assign the transition risk and say, oh, you are 2 degree compatible, or 3 degree compatible, or 1-1/2 degree compatible. Life is more complicated than that. And we need to communicate this complex picture in the right way to the decision-makers.

      So hopefully I give you some flavor of what kind of studies, what kind of approaches we are developing at our MIT Joint Program. And you're more than welcome to contact me. And I'm really looking forward for a Q&A session. And one more time, thank you very much to MathWorks for introducing me to this conference and for the opportunity to participate in this conference. Thank you very much. Thank you for your attention, and really looking forward to further interactions with you. Thank you.

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