Scenario Analysis in Climate Disclosures

Introduction to Scenario Analysis:

Businesses are now beginning to realise the impacts of climate change and the financial risks it poses in the short- and long-term. Given the large number of variables (technology, government policy, public behaviour, etc), it can lead to multiple possible futures. There is a need to understand these possibilities to alleviate uncertainty and support climate-focused business decisions. Scenario analysis is just the right tool for this. 

The basics of 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. 

It is feasible to understand and improve a company's resilience by anticipating possible responses to future risks in a variety of ways. One strategy would be to project present tendencies into the future. For example, consider a world in which EVs account for a significant share of the automobile market in the next 3 decades. Another strategy is to imagine several scenarios like "what if” by 2035, the EU imposed a carbon price on all emissions. A business can picture itself in a best-case, worst-case, and/or potential climatic future by considering such scenarios.

Climate-Related Scenario Analysis:

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 the increased frequency of weather events. A second type is characterized by models focused on the changes to the economy arising from societal behaviour, government policies, technology adoption and other events. 

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. For ex. changes in precipitation patterns and extreme variability in weather patterns, rising mean temperatures, etc.
• Transitional climate risks are the remaining set of non-physical climate risks, which usually take the form of policy, legal, technological, and market risks. For ex. exposure to litigation, shifts in consumer preferences, increased stakeholder concern, or negative stakeholder feedback.

Types of Scenario Analysis:

1. Qualitative Scenario Analysis 

Industry trends based on real data and analysis can be used in qualitative scenario analysis. It can also rely on historical and experiential information, making it a reasonable basis for those who are just getting started. Data collation for a qualitative scenario analysis can be as simple as gathering climate change-related experiential knowledge from several departments. Management can use this data to generate narratives about probable development paths in the future. While this activity is simple, it can provide decision-makers with insight into how climate change will affect their companies.

2. Quantitative scenario analysis 

Such analyses demand substantial data, but some datasets are freely available. Data collecting and monitoring systems may be required if data is not available. Companies can utilise numerical data to feed into climate models to simulate how their assets/operations would fare in a number of scenarios. Any climate risk expressed numerically can be assessed using quantitative scenario analysis. Quantitative scenario models can be used to examine both physical climate impacts (e.g. heatwaves, cyclones) and transition-related implications (e.g. carbon emission costs).

Choosing scenarios for an analysis:

Companies can disclose their climate risk management reporting by either building their own custom climate scenario or using a public one.

Building your own scenarios gives control over tweaking the parameters of most importance to your company. Choosing a widely used public scenario also gives the opportunity to directly compare your analysis results with peers.

Global Reference Scenarios:

1. IPCC Scenarios (RCPs and SSPs)

Current IPCC usage and modelling is based on representative concentration pathways (RCPs), which agreed upon, projected, plausible emission pathways through 2100. These pathways represent different emission projections under basic, plausible economic and social assumptions while staying within physical constraints. The following graphic encapsulates the RCP details.

For analytical clarity, RCPs did not originally include a socioeconomic “narrative” but only emissions trajectories calculated using certain assumptions about energy use. Instead, shared socioeconomic pathways (SSPs) have been developed subsequently to be used in conjunction with the RCPs. SSPs are intended to provide plausible scenarios for how the world evolves in areas such as population, economic growth, education, levels of globalization, level of urbanization, and the rate of technological development.

The five SSP scenarios range from better to worse climate change outcomes.

• SSP-1 sketches out a scenario with a significant focus on sustainability.
• SSP-2 is a “business as usual” scenario
• SSP-3 involves regional rivalry between countries
• SSP-4 has a high degree of inequality
• SSP-5 points fossil-fuel development

2. IEA Scenarios

IEA is one of the limited numbers of global, macroeconomic climate scenarios and predicted emission trajectories from organizations beyond the IPCC that are used widely enough to be considered reference scenarios. The IEA’s scenarios are published in their annual flagship report, the World Energy Outlook (WEO). The IEA scenarios are focused on transitional climate risks. 

The scenarios developed by IEA are:

3. Other Public Scenarios

Tools for Scenario Analysis:

• General: Climate Information Portal (CLIPC)
• Sector-specific or climate change impact-specific:  United Nations Food and Agriculture Modeling System for Agricultural Impacts of Climate Change, or the World Resource Institutes Aqueduct tool, which tracks water risks emerging around the world. 

Case Studies for reference:

• Use of scenarios for transition risk: HSBC
• Scenario Analysis for physical climate effects on operations: CITI
• Integration of scenario analysis into asset management: Abrdn