Climate scenarios and models were updated and expanded to enhance the assessment of the long-term impact of climate change on portfolio returns.

Following from the first scenario analysis in 2020, MAS updated the set of climate scenarios used to analyse the long-term impact of climate change on portfolio returns, in partnership with GIC, Ortec Finance and Cambridge Econometrics. The updated climate scenarios incorporated more recent developments in climate research and modelling, and to better account for the range of possible outcomes.

In the scenario analysis conducted in 2022, MAS continues to analyse the portfolio impact under the three key climate change scenarios in the 2020 study.

The portfolio impact under the two scenarios – Net Zero (“NZ”)MAS has replaced the Paris Orderly (“PO”) scenario in the 2020 study with the NZ scenario, which assumes global emissions reaching net zero by 2050. More ambitious climate actions are taken in the NZ scenario compared to the PO scenario. and Failed Transition (“FT”) - on opposite ends of the plausible spectrumThe NZ scenario has a climate outcome with moderate transition risk but low physical risk while the FT scenario has a climate outcome with low transition risk but high physical risk., reflect the best case and worst-case outcomes respectively.

MAS also included a bespoke Delayed Disorderly Transition (“DDT”) scenario to understand the portfolio implications of an ‘in-between’ climate outcome, with moderate transition risk but limited long-term physical risk impact. In the DDT scenario, a spike in occurrences of extreme weather events globally triggered governments to take decisive but disruptive policy changes to decarbonise the global economy aggressively to meet the Paris goal.

MAS introduced a new Too Little, Too Late (“TLTL”) scenario that incorporates elements of both the Delayed Disorderly Transition ("DDT") and Failed Transition ("FT") scenarios, to assess the portfolio implications of a plausible pathway that is both disorderly and still insufficient to limit physical climate risks.

MAS recognises that beyond the DDT scenario, there could be other disorderly transition pathways that point to different levels of physical risk impact and therefore affect long-term portfolio returns to different extents.

The TLTL scenario is characterised by repeated cycles of extreme weather events, followed by reflexive policy changes that produce a start-stop pace of fossil fuel curtailment, energy efficiency improvements, and renewables investment.

However, these policies and actions are ultimately insufficient to tackle climate change, with both policy impact and physical impact increasing in intensity throughout the 2030s.

In addition to updating the scenario set, MAS has also improved the richness of its scenarios by incorporating the effects of global food price shortages and inflation arising from climate change.

The 2020 scenario analysis modelled the effects of temperature changes on inflation caused by labour and agricultural productivity. The 2022 scenario analysis additionally measures the impact on inflation caused by food shortages due to crop destruction arising from an increased occurrence of unfavourable climate events (e.g., drought, flooding). The effects of global food price shortages caused by climate change is inflationary and counteracts the deflationary effects caused by a dampening of economic activity with rising temperatures.

MAS will continue to include improvements in climate modelling approaches in future updates, especially for physical risks.

This includes closing the known gaps in physical risk modelling, to allow for a more complete understanding of the potential impacts to the portfolio. For example:

• Incorporating further channels through which physical risks could impact the economy and hence asset prices when modelling techniques develop.
• Modelling for climate adaptation responses when more data becomes available.

Even so, climate models have not fully incorporated feedback loops and climate tipping points that when crossed could result in unpredictable outcomes. For example, higher temperatures from rising emissions, causing sea ice to melt and sea levels to rise rapidly. This widens the cone of uncertainty in assessing the impact of physical risks on the portfolio especially at higher temperature bounds. MAS will keep a close watch on scientific developments, and continue to update its climate modelling in tandem with improvements and advances in climate science.

The table below summarises the key parameters of the four climate scenarios:

The key findings from the 2022 scenario analysis are in line with those from 2020, validating MAS' strategy of taking early, scalable climate actions focusing on transition risk and equities in the portfolio.

• Equities remain the asset class most sensitive to the impact of climate change and is the main contributor to the lower portfolio returns across all scenarios compared to a climate uninformed baseline. The impact on bonds is more muted as the overall high credit quality of the portfolio is not expected to significantly deteriorate across climate scenarios. The well-diversified nature of MAS' portfolio, with a higher proportion of fixed income relative to equities, helps limit the negative impact of climate change on overall investment returns.
  
  
• Transition risk continues to be a more imminent risk to manage, with physical risk impacts projected to outweigh transition risk impacts in the longer term in scenarios with higher physical risks. Compared to transition risk, physical risk has more far-reaching effects on the economy and on the financial markets. Most sectors are expected to be impacted by physical risk, with impacts being most pronounced in the FT scenario. Therefore, although investors can take pre-emptive climate portfolio actions (for example, tilting the portfolio away from carbon intensive companies) to mitigate the impact of transition risk, it remains challenging to implement early portfolio actions to efficiently reduce the physical risk impact on the portfolio given the inherent uncertainties over the locus and timing of coinciding extreme climate events.
  
  
• Transition risk impacts vary significantly for companies across and within different sectors of the economy depending on their degree of alignment with the low carbon transition. Carbon intensive sectors are the most impacted by tougher policies and regulations to reduce emissions and mitigate climate change. Furthermore, even within carbon intensive sectors, the impact on companies is also expected to vary significantly depending on how companies respond to and prepare for climate change. Tilting MAS' portfolio away from carbon intensive sectors selectively, and to companies within carbon intensive sectors that are better aligned with the low carbon transition could increase the resilience of the portfolio against an accelerated transition to a low carbon economy.
  
  
• MAS needs to be prepared for larger and more volatile shifts in asset prices should the disorderly transition scenarios materialise. In scenarios where climate mitigation is delayed, the stronger policy actions needed to reduce emissions within a shortened timeframe could result in much higher levels of asset stranding, supply chain shocks, and shift in consumer demand causing capital markets to overreact when pricing in climate risks. Overall risk sentiments could be further dented given the coinciding impacts of physical and transition risks that were modelled for in the Delayed Disorderly Transition ("DDT") and Too Little Too Late ("TLTL") scenarios. This suggests the need to make pre-emptive adjustments to MAS' portfolios, in an incremental but scalable manner, without making assumptions about how markets might potentially react to pricing-in and sentiment shocks arising from climate transition risks and opportunities.

As there are still material uncertainties around the transition pathways (ranging from a net zero transition to a failed transition, and the two disorderly transition scenarios in between), MAS needs to be prepared for all plausible climate scenarios as long-term investors. Understanding how climate change could affect portfolio returns at the extreme bounds from the transition, physical and the associated market risk perspectives would put MAS in a better position to take appropriate portfolio actions arising from shifts in the direction of the transition and their attendant implications for portfolio returns and asset allocation decisions.

The maturing of methodologies and the advancement of climate science for the modelling of physical risks that are still being studied by a wide range of experts would help MAS gain a richer understanding of physical risk impacts across different climate scenarios, and the extent to which MAS would have to accommodate for potentially lower expected portfolio returns in the worst-case scenario of a failed transition.

Given the key findings of the scenario analysis, MAS formulated a set of targeted portfolio actions that are aimed at positioning the equities component of the Official Foreign Reserves ("OFR") portfolio to protect from transition risks and gain exposure to suitable sustainability themed investment strategies. These are highlighted in the next section.