Where and How to start with Climate Scenario Analysis?

This is the second part of the introduction to climate scenario analysis. You can read the first one here

Let’s Talk about TCFD!

In December 2015, the Financial Stability Board mandated the Task Force on Climate-related Financial Disclosures (TCFD) to draw up recommendations for reporting to help stakeholders in financial markets understand their climate-related risks and opportunities (“Navigating climate scenario analysis”, IIGCC, 2019). TCFD isn’t about the impact of the company on the environment, it is about the environment’s impact on the company. These disclosures are targeted at mainstream investors and are intended to help them assess whether climate risk is appropriately priced into their valuation of the company. The final report of the TCFD published in 2017 includes recommendations across four pillars: governance, strategy, risk management, and metrics and targets.?

Each of these pillars have supporting recommended disclosures. One of the key recommendations under the “Strategy” pillar is for corporates and financial institutions to “describe the resilience of the organisation’s strategy, taking into consideration different climate-related scenarios, including a 2°C or lower scenario and, where relevant to the organisation, scenarios consistent with increased physical climate-related risks”.

How to start performing Scenario Analysis?

An organization, as it gains experience in conducting scenario analysis can do the following

The choice of approach will depend on an organization’s needs, resources, and capabilities. Organizations that are likely to be significantly impacted by climate-related transition (risks while moving towards a low-carbon economy) and/or physical risks should consider some level of quantitative scenario analysis. Quantitative approaches may be achieved by using existing external scenarios and models provided by third-party providers or by organizations developing their own, in-house modelling capabilities. Before conducting scenario analysis, an organization has to understand the

1. Relevant climate-related scenarios
2. The risks and opportunities it may face.

Climate-related Scenarios

The scenarios developed by the International Energy Agency (IEA) and Intergovernmental Panel on Climate Change (IPCC) have long been used by scientists and policy analysts to assess future vulnerability to climate change. Climate-related scenarios can be broadly assigned into two categories:

-----> Transition Scenarios

• Focuses on the technological, political, legal, market and economic changes required to reach a certain pathway, and the associated risks and opportunities. Hence, these scenarios can aid in the analysis of the impacts which may arise from a transition, such as to a low-carbon economy.
• These scenarios can reflect a faster or slower transition depending on different rates of change of key parameters (e.g., the rate of technology development and deployment; changes and timing of key policies; etc.). IEA produce several transition scenarios.

-----> Physical Scenarios

• Focuses on the physical impacts due to climate change such as extreme weather events. Physical climate scenarios typically present the results of global climate models (referred to as “general circulation models”) that show the response of the Earth’s climate to changes in atmospheric GHG concentrations.
• IPCC scenarios based on “Representative Concentration Pathways” (RCPs) are examples of physical climate change scenarios adopted by the IPCC in its 5th Assessment Report (AR5).
• Model results are frequently “downscaled” to derive potential local-level changes in climate, which are then used to generate scenarios of impacts from climate change (first-order impacts such as flooding or drought, second-order impacts such as loss of crop production, and third-order impacts such as famine).

Climate Risks and Opportunities

While some organizations are affected by transition risks, others which have a large number of physical infrastructures and assets are vulnerable to physical climate risks. However, both risks are required to understand the full implications of climate change and the resilience of organizations to those implications. An organization should consider some of the following the risks and opportunities while conducting scenario analysis (Sources: CDP, “Climate Change Questionnaire,” 2017; TCFD, Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures, June 2017).

The Scenario Analysis Process

First, the organization has to ensure that governance is in place:

• Integrate scenario analysis into strategic planning and/or enterprise risk management processes.
• Assign oversight to relevant board committees/sub-committees.
• Identify which internal (and external) stakeholders to involve and how.

Once the process is complete the final step is to document and disclose it:

• Document the process
• Communicate to relevant parties
• Be prepared to disclose key inputs, assumptions, analytical methods, outputs, and potential management responses.

While conducting scenario analysis organizations face several choices and considerations which affect whether scenarios are applied consistently, analyses and disclosures are comparable, and the process is efficiently applied. Major categories of considerations include:

• Parameters Used (e.g., discount rate, GDP, other macro-economic variables, demographic variables)
• Assumptions Made (e.g., assumptions related to policy changes, technology development/deployment, energy mix, price of key commodities or inputs, geographical tailoring of transitional and physical impacts, and timing of potential impacts)
• Analytical Choices (e.g., choice of scenarios, time horizons, supporting data and models)

Transparency around key parameters, assumptions, and analytical choices will help to support the comparability of results between different scenarios used by an organization and across organizations and also improve the robustness of the disclosures.

Scenario Analysis: Yay or Nay?

Scenario Analysis is an established method that helps an organization develop and plan robust and flexible strategies for a range of future states. It helps to be aware and better prepared for existing and future risks and opportunities even those that are uncertain and disruptive. Climate-related scenario analysis can provide the foundation for more effective engagement with investors on an organization’s strategic and business resiliency. ?

However, there are challenges involved as well. Transparency, the functionality of tools and the range of data are still not ideal for many of the climate scenarios.

-?????????A majority of transition scenarios provide outputs such as the energy mix under given circumstances in the future, but not sector-or activity-specific results in most instances.

-?????????The outputs of climate modelling of physical scenarios, undertaken within the framework of the IPCC, are currently not easily accessible to the wide majority of organizations.

Data availability and resolution is another issue for organizations attempting to assess various energy and technology pathways or carbon constraints in different jurisdictions and geographic locations. Climate Scenario Analysis is still in the early stage and therefore, sharing experiences and approaches to scenario analysis across organizations is critical for improvement. As mentioned in the TCFD report –

“Addressing these challenges may require further work by industry groups, NGOs, and official bodies, both individually and collectively, to:

-?????????further develop applicable 2°C (or lower) scenarios at the sector and geographic level and create industry-specific (financial and non-financial) guidance for preparers and users of climate-related scenarios

-?????????further develop, and improve access to, methodologies, data sets, and tools that allow organizations to more effectively conduct scenario-based analysis of transition and physical risk at more granular industry, geographic, and temporal levels

-?????????develop and refine accepted good practices for scenario-based climate-related financial disclosure and facilitate uptake by sectors most greatly impacted by climate change

-?????????establish stronger norms for better, relevant disclosure around scenario analysis

-?????????develop guidance for investors to better understand and use scenario-related disclosures “

As the world is hurtling towards the inevitable 1.5°C target, organizations must pick up pace in setting their targets and becoming aware of what is happening within the organizational structure. They have to start collecting information and data on their current management and strategy towards climate change and improve their reputation and resilience by being better prepared for existing and future climate-related risks and opportunities through scenario analysis.

Net Zero Think, a climate-focused service provider is providing climate change impact assessment for different climate scenarios to help organizations understand climate risks and become more climate resilient. To know more, send an enquiry to [email protected] or visit www.netzerothink.com

Author: Dr. Kruthika Eswaran?(Lead Consultant for Climate Change Impact Assessment)