There’s a rapidly growing consensus among top global business leaders that the impacts of climate change pose a sizable financial risk in the short- and long-term. Despite this recognition, companies are unsure how climate change will unfold. Governments are continually introducing new policies, technologies are rapidly evolving, and people’s behaviours are in constant flux. When combined, these variables can lead to multiple possible futures. How can you, as a decision-maker, better understand these futures to alleviate uncertainty and support climate-focused business decisions? Enter the forward-looking tool: scenario analysis.
What is Scenario Analysis? The Basics of Scenario Analysis
Scenario analysis looks at plausible future pathways of development (scenarios) that will lead to different outcomes. Considering the implications of these scenarios on assets and operations helps businesses understand how current or potential trajectories could drive business value.
Scenario analysis can be applied to any number of trends and future pathways. For example, a financial institution could explore potential future compositions of the energy industry. Or, governments could explore different responses to global pandemics. Increasingly, we are seeing it being used to analyze how climate change might impact an organization.
Scenario Analysis and Climate Change: What is Climate Change Scenario Analysis?
Scenario analysis can be applied to plausible climate futures for understanding how climate change impacts an organization. Climate scenarios are developed by considering an array of factors ranging from atmospheric changes to societal behavioural changes to new government policies to technological breakthroughs. Some of the most commonly used scenarios include the International Energy Agency’s (IEA) climate scenarios and the Representative Concentration Pathway (RCP) scenarios (see page 21 of the linked report).
Climate Related Scenario Analysis: Types of Scenarios
Generally speaking, there are two types of scenario modelling when considering types of climate impacts. One group of climate scenario models focuses on the changes that happen in the physical world, such as increased frequency of weather events. Companies such as real estate or mining might find this type more useful. A second type is characterized by models focussed on the changes to the economy arising from societal behaviour, government policies, technology adoption and other events. These may be more useful to organizations analyzing risks and opportunities from the transition to a low-carbon economy. However, some companies such as in the energy sector may be exposed to both types of risks. Click here for our blog How to Get Started with Scenario Analysis on how to choose the most relevant climate scenario.
The Task Force on Climate-related Financial Disclosures (TCFD) therefore groups climate risks into two buckets: physical and transitional scenarios. Physical climate risks are risks to the physical integrity of business assets and operations due to climate change. These range from flood damage due to increased precipitation to worker health and safety concerns due to rising temperatures. Transitional climate risks are the remaining set of non-physical climate risks, which usually take the form of policy, legal, technological, and market risks. These include increased exposure to liability due to changing environmental regulations or the risk of sunk legacy assets due to rapidly evolving technologies.
How is Scenario Analysis Useful?
Understanding and Improving your Resilience
Envisioning possible responses to future risks can be done in a variety of ways. One approach would be extending current trends far out into the future. For example, a company might imagine a future where electric vehicles make up a large portion of the automotive market by 2050. Another approach would be picturing different “what if?” scenarios. For example, what if every G20 country had a carbon price for all emissions by 2050?
By considering different scenarios, an organization can envision itself in a best-case, worst-case, and/or most likely climate future, and everything in between. This exercise enables decision-makers to understand their organization’s resilience to a multitude of climate risks. This information can then be used to help executives understand the gravity of climate impacts on their businesses or even to inform long-term strategy.
What Scenario Analysis is and isn’t
It’s important to remember that scenario analysis is a tool for expanding an organization’s thinking. It inspires discussion among decision-makers about potential futures for their organization based on data (physical or transitional). In doing so, organizations are better prepared for the future.
Scenario analysis should not be confused with prediction. It is not a tool for forecasting the future. Through scenario analysis, companies can consider a range of different climate risk combinations to assess their financial, strategic, and operational ramifications.
As a changing climate threatens business as usual in all sectors, companies need a dependable tool for building value in an uncertain future. By providing a method for considering business strengths and vulnerabilities under a range of plausible futures, scenario analysis is the tool that businesses need.
Examples of Scenario Analysis
The Bank of Canada and OFSI recently announced a climate scenario analysis pilot project with a final report planned for the end of 2021. In this project, the two organizations will develop Canada-specific climate scenarios for pilot participants to analyse their risk exposures. These analyses will then be used to understand the Canadian economy’s resilience to climate change. This showcases the potential breadth of climate scenario analysis. In this case, it is being used to understand how different climate change trajectories will affect an entire nation’s economy.
OPTrust’s 2017 Portfolio Climate Risk Assessment report is a great example of using scenario analysis to consider multiple futures. The report analyzes four potential future pathways covering a 35-year period. The report outlines OPTrust’s ongoing climate work and provides recommendations for climate impact assessment at the asset and industry sector levels. It also contains suggestions for developing potential actions in response to these risks.
BP also analyzed four climate scenarios from 2019 to 2040. They also consider several “alternative scenarios” to dive deeper into specific, more narrowly-defined potential futures. Examples of such potential futures include a future with single-use plastic bans and a future with escalated trade disputes.
A slightly different approach was adopted by the Industrial and Commercial Bank of China (ICBC). They conducted a stress test, which is a form of scenario analysis, to assess the credit risk impacts of environmental factors on their loans.
These examples show that there is no template for conducting a scenario analysis. Every organization has different assets, operations, socioeconomic and political contexts, and other factors that make it unique. The organization’s priorities should be accommodated in developing their own bespoke scenario analysis. By focusing on factors specific to itself, an organization can gain greater and more customized insight into how climate change may impact its future.
Scenario Analysis and the TCFD: What is Scenario Analysis in Risk Management?
The TCFD, which is widely recognized as the gold standard framework for climate related financial disclosure, provides financial institutions with disclosure recommendations for climate risk management reporting. One of the recommendations is to disclose the company’s resiliency strategy under climate scenarios. Companies can do this by either building their own climate scenario or using a public one. Certain organizations, such as the IEA, publish extensively on climate scenarios applied to the energy industry. Their latest climate scenarios can be found in their World Energy Outlook 2020 report. Alternatively, the TCFD listed a number of public scenarios in their 2020 Guidance on Scenario Analysis for Non-Financial Companies (see Appendix 1). These are good places to start. It is likely that more companies will follow this recommendation as institutional investors, major financial organizations, and governments are starting to demand TCFD-aligned disclosures.
The growing push for TCFD disclosures can be seen globally. Mark Carney, former Governor of the Banks of Canada and England, has repeatedly praised the framework. In August of this year, he called for TCFD reporting to be made mandatory. In 2020 alone, we saw both New Zealand and the United Kingdom introduce mandatory TCFD disclosure regulations. This surging demand was even seen domestically. The Government of Canada’s COVID-19 relief program, the Large Employer Emergency Financing Facility (LEEFF) program, required a commitment to TCFD disclosure from applicants. Evidently, TCFD disclosure is rapidly growing, and it is expected to continue to grow according to the TCFD’s 2020 Status Report. With the rising popularity of the TCFD, we can expect to see more scenario analyses in the near future.