The world is currently facing a serious threat from climate change. Despite technological advancements in weather forecasting techniques, the scientific community still needs to be made aware of the extent and severity of the environmental impacts. The rationale for this uncertainty lies in the complex nature of climate change and the accompanying effect of continual shifts in weather patterns. Climate scenario analysis is a category of sensitivity analysis that is a way forward for organisations and business leaders in mitigating climate-related risks and helps improve the resiliency of their business operations. Traditional methods of future planning, such as forecasting, only predict weather-related changes and their impact on assets and business operations. In contrast to traditional methods, scenario analysis provides more detailed and precise predictions about future events. Moreover, scenario analysis helps businesses in analysing and preparing for the uncertain future conditions related to climate change. Scenario analysis may serve as a valuable resource tool for organisations. This article will elaborate and highlight the strategic value of scenario analysis and how organisations utilise these tools for building resilience and enhancing efficiency [1], [2].
What Is Scenario Analysis?
Scenario analysis is a methodology for evaluating potential uncertain future events and is deployed to make more informed decisions in the present. A scenario is a hypothetical concept that represents a pathway for developing a certain future outcome. Scenarios are not considered forecasts or predictions and do not fully describe the future, but instead emphasise major characteristics of the possible future. Climate Scenarios outline various possible future conditions regarding the world, depending on the impact of policies and actions on the course of climate change and associated issues. Scenario analysis is utilised by businesses for a forward-looking assessment of risks and opportunities derived from climate change. Scenario analysis serves as a valuable tool to enhance critical strategic thinking. It can be utilized to challenge the traditional notions of the future by presenting various possible choices. Its application within the context of climate change is becoming increasingly beneficial, as it aids organizations in comprehending how potential climate risks and opportunities may develop and affect their business operations [3].
Climate-Related Scenarios
Climate scenarios characterise various possible future climate events that can be defined under Representative Concentration Pathways (RCP) frameworks as well as other pathways. RCP was first defined by the Intergovernmental Panel for Climate Change (IPCC) in 2014, which elaborated several future greenhouse gas (GHG) concentration trajectories. These pathways usually possess two primary characteristics: i) the average global temperature rise, which has a greater direct impact on physical risks since rising temperatures cause more severe and frequent weather events; and ii) global climate policies that contribute to this potential temperature rise, which have a greater direct impact on transition risks because lowering emissions through policies will reduce temperature rise at the expense of transitional risks for businesses. The IPCC has defined seven distinct RCPs in total. The RCP 1.9 is a pathway related to the annual lowest temperature rise of 1.5°C in line with the goal of the Paris Agreement. The RCP 8.5 is a pathway considered the worst-case climate change scenario related to the annual highest temperature rise of 4.3˚C by 2100. Every scenario presents various transitional and physical risk data that analysts can utilize to forecast future economic outcomes based on different climate change pathways [1].
Scenario Analysis & TCFD Recommendations
The Task Force for Climate-related Financial Disclosures (TCFD) was established by the Financial Stability Board (FSB) to develop recommendations for businesses, investors, and financial institutions in the disclosure of their information related to climate change risks and opportunities. The TCFD recommendations are considered the benchmark for companies to report sustainability data besides financial data. Scenario analysis is considered one of the key recommendations of TCFD. The Task Force recommends that organisations define the resilience of their strategies by considering various climate-related scenarios, including those that adhere to a 2°C or lower benchmark, when such details are significant [4], [5].
How to Conduct a Scenario Analysis?
Scenario analysis is unique to each organisation, influenced by various factors including the sector, industry, geographical locations of operations, supply chain dynamics, organisational structure, and the interests of key stakeholders. Each of these elements plays a crucial role when evaluating how climate risks and opportunities may impact a business. To create a comprehensive and tailored scenario analysis that addresses the specific risks and opportunities faced by an organisation, one can follow a structured six-step process. This approach ensures that all relevant characteristics of the organisation are examined, allowing for a thorough understanding of potential climate-related impacts [6]:
Ensure Governance: Organisations should incorporate scenario analysis into the strategic decision-making process by involving key internal and external stakeholders.
Assess Materiality of Climate Risks: Companies have to conduct materiality assessments related to climate risks. For instance, companies have to determine the important factors associated with the operation and financial functions. Organisations also have to discover what physical and transition risks affect their overall business operations. Moreover, businesses shall have to consider technological and legal considerations relevant to their organisation.
Identify and Define a Range of Scenarios: In this step, companies will determine all possible climate events that can happen. This will include risks and opportunities related to transition risks, such as a carbon tax, and physical risks, such as probable damage by hurricanes and floods.
Evaluate Business Impacts: Now organisations will assess the potential effects on the business by evaluating how different scenarios may influence operational expenses, regulatory compliance costs, supply chain dynamics, and the risk of interruptions to business activities.
Explore Possible Responses: These may involve investing in new technologies, adjusting business models and processes, and diversifying investments in portfolios.
Document and Disclose: In the last step, it is essential for businesses to thoroughly document the scenario analysis process and transparently share these findings in their annual sustainability reports.
What is Stress Testing?
Stress testing, a widely recognised risk management method, has been instrumental in evaluating financial stability since its introduction after the 2008 global financial crisis. Initially developed to analyse non-climate-related risks like economic downturns, it has become a cornerstone for central banks worldwide. Institutions such as the Federal Reserve and the European Central Bank routinely conduct these tests to ensure that banks are resilient against diverse market conditions, including severe economic disruptions. A climate stress test evaluates the vulnerability of financial institutions to the risks posed by climate change, including the financial system's exposure to rising global temperatures. These assessments aim to identify vulnerabilities and help institutions better understand and manage climate-related financial risks. Supervisory authorities worldwide are increasingly implementing or planning to conduct such exercises, recognising the growing importance of climate resilience. Already, several financial regulators have completed or are actively preparing to perform these stress tests as part of their climate oversight efforts [7].
Implementation of a Climate Stress Test
Although climate stress testing is still in its early stages, several regions have already started or completed their climate stress testing. To support and standardise these efforts, the Network for Greening the Financial System (NGFS) presents guidelines on implementing climate stress tests. This includes advice on scenario design and technical assistance, ensuring a more cohesive and effective approach across regions [8].
Two Approaches: Top-Down vs. Bottom-Up
There are two primary approaches applied for performing climate stress testing: top-down and bottom-up. There is a considerable difference between both approaches regarding data analysis techniques, model outputs, and resources required [8]:
Top-Down Approach: In this approach, the supervisory authority conducts the test without the involvement of a financial institution. The supervisor develops a set of scenarios by themselves to assess the potential impact on financial institutions by utilising their data and methodology. The approach assesses risk at a macroeconomic level, providing a holistic view.
Bottom-Up Approach: In this approach, the supervisory authority sets the stage for financial institutions by highlighting common scenarios and a set of methodological rules. The financial institution then conducts scenario analysis by utilising scenarios and feeding back into it their internal data and models. The supervisor aggregates results from participating institutions. The process can include organizations evaluating the possible effects of climate risks at the asset or portfolio level to gain insight into operational vulnerabilities.
Both approaches have benefits and drawbacks. A top-down approach is often preferred for its consistency in applying a uniform methodology across financial institutions. The top-down approach simplifies adjustments to assumptions and parameters, making it less resource-intensive. On the other hand, a bottom-up approach provides deeper insights into individual institutions' internal methods and their capacity to assess climate risks effectively. A bottom-up approach is particularly useful for enhancing climate scenario analysis skills and raising awareness about the potential impacts of climate change within organisations [9].
Two-Level Analysis: Counterparty and Portfolio
Financial institutions can incorporate individual or any combination of two types of analysis into their climate stress testing program [7]:
Counterparty-level analysis: This analysis emphasised the importance of evaluating potential climate risks and opportunities of individual counterparties within the financial institution. Factors assessed may include the counterparty's geographical and sectoral exposure, along with their resiliency or transition plans. The assessment results can inform decision-making concerning individual clients and exposure.
Portfolio-level analysis: This analysis focused on how climate change may affect a full portfolio, including various assets, investments, and financial products. The assessment offers a consolidated perspective on asset combinations and exposures. These assessment findings can guide the development of company-wide strategies.
Time Horizons: Short-Term and Long-Term
Selecting a time horizon for conducting climate stress testing is an important factor for decision-makers. Both short-term and long-term time horizons can variably benefit organisations in minimising climate risks [7]:
Short-Term Scenarios: Many companies are now adopting scenarios with shorter time horizons in conducting climate stress testing. Previously, short-term time horizons were used by companies for traditional stress tests. Now short time horizons that span over two to five years are typically used by financial institutions for capital and strategic planning.
Long-Term Scenarios: Long-term spans over decades and includes efforts targeted to global agendas. The Paris Agreement is a classic example of a long-term scenario in which the worldwide community agreed on the efforts to decrease greenhouse gas (GHG) emissions and therefore limit global warming to well below 2°C, and ideally to 1.5°C. Long-term scenarios help predict gradual changes in environmental patterns. However, long-term time frames may become challenging in macroeconomic projections and financial impacts.
Many supervisory authorities and financial institutions have integrated both short- and long-term horizons for analysing the precise impact of climate change over a longer period. Moreover, short-term impacts of financial stability are also projected to aid in institutional preparedness.
Conclusion
Climate stress testing is a vital tool for assessing and addressing the financial risks posed by climate change. TCFD-recommended scenario analysis is a reliable tool for evaluating climate risk in a precise manner. Organisations can greatly benefit from scenario analysis as a part of their strategic planning for the future. Scenario analysis can be conducted by a simple six-step methodological approach. Climate stress testing provides a broader aspect for evaluating climate risk in different scenarios. By integrating top-down and bottom-up approaches, as well as short-term and long-term time horizons, organisations can balance methodological consistency with tailored insights into their unique climate vulnerabilities. By adopting climate stress testing and scenario analysis, institutions can proactively manage risks and be better prepared for climate change.
How SmartResilience Can Help?
Smart Resilience is a company dedicated to empowering businesses to navigate the challenges of climate change. With a focus on sustainability and long-term success, we offer tailored solutions to assess and mitigate climate-related risks. Our comprehensive suite of services empowers businesses to combat climate challenges while aligning perfectly with the requirements of the Corporate Sustainability Reporting Directive (CSRD).
Our comprehensive services include:
Physical Risk Assessments: SmartResilience conducts in-depth physical risk assessments, to identify vulnerabilities to extreme weather events and other climate-related hazards. These assessments directly address the CSRD's mandate for climate risk disclosure and potential impacts.
Scenario Analysis: SmartResilience scenario analysis tools evaluate the impact of diverse climate scenarios on your business operations. By strategically considering various possibilities, you can plan for the future, enhance financial resilience, and align seamlessly with the CSRD's mandate for future-proof planning.
Risk Management Strategies: SmartResilience goes beyond identification by developing comprehensive and tailored risk management strategies. Our solutions safeguard businesses against climate change impacts, emphasising the CSRD’s call for proactive adaptation measures.
Ongoing Compliance Support: SmartResilience provides continuous support to ensure your sustainability reporting remains compliant with evolving CSRD requirements. Our services include regular updates to reflect the latest regulations, staff training to maintain expertise, and vigilant monitoring for accurate and up-to-date disclosures.
Partnering for a Sustainable Future:
The future may be uncertain, but by building resilience together, we can address climate change with confidence and clarity. Contact us today to embark on a journey towards a sustainable future.
References
[1] N. Daly, M. Lin, A. Liu, O. Pazumak, and S. Waqar, “Climate Scenario Analysis.” KPMG, Jul. 2024. [Online]. Available: https://kpmg.com/kpmg-us/content/dam/kpmg/pdf/2024/climate-scenario-analysis.pdf
[2] FMA, “Climate-Related-Disclosure-Scenario-analysis-information-sheet.” Financial Markets Authority – Te Mana Tātai Hokohoko (FMA), Oct. 2023. [Online]. Available: https://www.fma.govt.nz/assets/Guidance/Climate-Related-Disclosure-Scenario-analysis-information-sheet.pdf
[3] A4S, “A4S Guide to TCFD Climate Scenario Analysis - A guide for finance teams on frequently asked questions.” The Prince of Wales Charitable Fund, Jun. 01, 2024. [Online]. Available: https://www.accountingforsustainability.org/content/dam/a4s/corporate/home/KnowledgeHub/Guide-pdf/A4S%20Guide%20to%20TCFD%20Climate%20Scenario%20Analysis.pdf.downloadasset.pdf
[4] TCFD, “About Task Force on Climate-Related Financial Disclosures (TCFD),” Task Force on Climate-Related Financial Disclosures. [Online]. Available: https://www.fsb-tcfd.org/about/
[5] TCFD, “TCFD Recommendations,” Task Force on Climate-Related Financial Disclosures. [Online]. Available: https://www.fsb-tcfd.org/recommendations/
[6] Persefoni, “TCFD Scenario Analysis: An Overview - Persefoni,” Persefoni. [Online]. Available: https://www.persefoni.com/blog/tcfd-scenario-analysis
[7] United Nations Environment Programme (UNEP), “A Comprehensive Review of Global Supervisory Climate Stress Tests,” United Nations Environment Programme Finance Initiative (UNEPFI), Geneva, Jul. 2024. [Online]. Available: https://www.unepfi.org/themes/climate-change/a-comprehensive-review-of-global-supervisory-climate-stress-tests/
[8] N. Florenzio, “Climate Stress Tests: an Overview,” E-Axes Forum, p. 12, Apr. 2023.
[9] “Guidelines on institutions stress testing,” European Banking Authority, Final Report EBA/GL/2018/04, Jul. 2018. [Online]. Available: https://www.eba.europa.eu/sites/default/files/documents/10180/2282644/2b604bc8-fd08-4b17-ac4a-cdd5e662b802/Guidelines%20on%20institutions%20stress%20testing%20(EBA-GL-2018-04).pdf?retry=1
