What is all the fuss about climate-related scenario analysis, and why should you care?
November 8, 2022
World leaders are gathering in Sharm el-Sheikh, Egypt this week for the 2022 United Nations Climate Change Conference (COP27). They represent most of the world’s countries that are signatories to the 2015 Paris Agreement, wherein they committed to “holding the increase in global average temperatures to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C.” The commitment is based on climate change modelling that shows once we reach 2°C above pre-industrial levels, more extreme and frequent weather events and warming present challenges to human health, access to food and water, damages to land and infrastructure, and displacement of workers.
To achieve the “well below 2°C target,” the global economy needs to be Net-Zero by around the middle of the century, or 2050. It needs to stop adding greenhouse gases (GHGs) to the environment, and in fact needs to remove some that currently exist.
What’s the business impact?
All sectors of the economy, and all businesses, will be impacted by climate change. Each will have their own unique set of climate change risks, including opportunities to mitigate these risks, and if done correctly, some will have opportunities to profit from solutions to climate change. As part of the risk planning process, investors are increasingly demanding that climate-related risks and opportunities in particular be identified and priced to allow markets to allocate capital appropriately. This is why, as of 2021, according to the Science Based Targets Initiative, 70% of the global economy is covered by Net-Zero pledges. To drive the point home, RBC’s recent 2022 Global ESG Credit Investor Survey finds that environment, social, and governance (ESG) ratings, controversy levels, and climate metrics and risks are the key ESG drivers impacting investment decisions (RBC, 2022 Global ESG Credit Investor Survey, 2022 (link)).
What is the first step?
If organizations are going to identify the impact of climate change on their business, they need to understand what the future risks are. If the world achieves a 1.5°C limit the risks are monumentally lower than if end up at 2.8°C, which is where the UN Environment Programme (UNEP) predicts the range will be in 2100 under current policies. So, like any risk planning process, businesses need to do scenario analysis to plan for a number of different possible outcomes, and, based on their assessment which should be updated regularly, prepare to address the outcomes it determines are most credible and likely.
This is where climate-related scenario planning comes in. By assessing a number of climate change scenarios or hypothetical outcomes (referred to as “pathways”), businesses can understand how climate change physical and energy transition risks may impact their business, their strategies and their financial performance. For this reason, the Task Force on Climate-Related Financial Disclosures (TCFD), a global organization of investors, banks and insurance companies, is strongly recommending business conduct climate-related scenario analysis. By considering a range of possible climate-related outcomes, businesses can model how they might perform under different scenarios, and how they can build resilience to the pathways they determine to be credible and likely. This will allow them to better understand and respond to risks and opportunities. It will also allow investors to price in risks appropriately.
Most companies are not conducting climate-related scenario planning. As reported by EY Canada, “the research shows only 41% of companies in the study conducted scenario analysis” (EY Canada, Global Climate Risk Disclosure Barometer, 2021 (link), p. 9). Without understanding and considering credible hypothetical climate outcomes, the chances that a business has planned to mitigate the considerable risks is very low. As the report notes:
“Because climate-related risks are inherently more complex and long term than most traditional business risks, scenario analysis is essential for organizations to understand the physical, economic and regulatory connection between future climate impacts and business and supply chain activities.” (p. 19)
Why are businesses not conducting climate-related scenario analysis?
Three words: “it is hard.” A business needs to undertake a coordinated effort across its organization to produce a credible climate-related scenario analysis. This process includes:
Businesses also need to review and update the scenario modelling on a regular basis. Inputs and assumptions underlying climate-related scenario analysis are shifting quickly. This includes changes to legal and policy requirements, market and technology shifts, the understanding of physical risks, and demands from stakeholders and the impact this causes on reputational issues for businesses.
The good news
There are well-developed methodologies for conducting climate-related scenario analysis. This includes existing scenarios which have been developed by public organizations such as the International Energy Agency and the Intergovernmental Panel on Climate Change, to name a couple. Existing models can be customized to take into account the unique factors each business faces, such as:
The climate-related scenario analysis process takes up valuable resources and requires concerted effort and coordination across an organization. But investors and regulators will increasingly have less tolerance for the lack of such risk planning, and businesses that undertake credible climate-related scenario planning, like any good risk planning and management process, will have a significant competitive advantage.
Sustrio ESG Advisors helps educate businesses on climate-related reporting, understand the international reporting regimes, perform scenario analysis, and produce quality, data-driven disclosures relevant to investment and financial markets. Connect with us to see how we can help your company navigate the energy transition and report on all your ESG matters.