Applying Scenario Analysis in Understanding your Climate-related Risks and Opportunities

 

by Lim Sze Wei & Stefan Ullrich.

Investors are beginning to get on board with the global fight against climate change, a movement that was until recently the territory of non-profit organisations and environmentalists. According to the inaugural Global Climate Index 2017 for Asset Managers by the Asset Owner Disclosure Project (AODP), a majority of 60% of asset owners are now taking action on climate change, while 40% continue to ignore the associated risks and opportunities. The report also found that the world’s top 50 asset managers are well ahead of their asset owner clients in their approach to managing the financial impact of climate change on investment portfolios [1]. Blackrock, the world’s largest investor with US$6.317 trillion [2] assets under management (AUM) has warned that high-level directors could be voted out of companies that are failing to mitigate climate-related risks posed to individual firms [3].

Investors are increasingly paying more attention to companies’ environmental, social, and governance (ESG) issues, urging them to disclose the impacts of climate change on their business and assessing how these topics are managed. It is therefore very likely that shareholders will increasingly demand responses to ESG related topics, specifically climate-related risks, in the near future.

In response to the growing demand for organisations to properly assess, understand and report climate-related risks, and at the request of G20 leaders, the Financial Stability Board (FSB), a body that makes recommendations on the global financial system, established the Task Force on Climate-related Financial Disclosures (TCFD) in December 2015.

In its recommendations for organisations from both the financial and non-financial sectors, published in June 2017, the Task Force concluded that a key forward-looking tool to grasp the complexities of climate change is scenario analysis and recommended that companies explore physical, strategic, and financial risks and opportunities that could emerge from a range of climate-related scenarios, including a 2oC scenario. (Note: An increase of global temperature by more than 2°C has come to be the majority definition of what would constitute intolerably dangerous climate change. The UNFCC Paris Agreement’s key aim is to keep global temperature rise to well below 2°C above pre-industrial levels and to ideally limit the increase to no more than 1.5°C.)

What is scenario analysis?

Scenario analysis (sometimes called “scenario planning” or “scenario and contingency planning”) is a structured process for organisations to analyse possible future events by considering several scenarios i.e. stories about how the future might unfold and how it will affect them. It is a tool that intends to explore alternatives that may significantly alter the basis for “business-as-usual” assumptions, therefore enhancing critical strategic thinking.

While scenario analysis is a relatively recent tool to asses climate-related risks and opportunities and their potential business implications, it is an established method for developing strategic action plans that are flexible and robust to cover a range of future states.

Scenario analysis is also a good ‘storytelling’ tool in connecting the various and complex interactions, behaviours and emergent properties of our natural, economic and social systems. It recognises the ‘human science’ perspective in the diverse epistemologies of the climate, economic, and social narrative. It assists multiple business actors to broaden the focus to encompass a richer set of considerations thus providing decision makers with the understanding of complex systems associated with climate-related risks and opportunities, effects from various forms of intervention, and to then tailor strategic and targeted approaches in managing these risks.

The tool is also useful in helping transcend sustainability and climate change discussions from just the sustainability department, into the boardroom and the offices of the CFO, COO, CIO, etc. – thereby strengthening internal relations of an organisation and its ability to respond quickly and effectively to emerging threats and opportunities.

Given that the foundation of scenario analysis is based on forward-looking assessments, it is also a useful communications tool for informing stakeholders about the organisation’s position pertaining to climate-related risks and opportunities.

How to use the scenario analysis?

If your organisation is just beginning to use scenario analysis, the TCFD recommends that you can begin with qualitative scenario narratives of storylines. As your organisation gains experience with qualitative scenario analysis, the scenarios and associated analysis of development paths can be guided by quantitative information such as using datasets and models (e.g. developed in-house or provided by third-party providers) to illustrate pathways and outcomes.

In identifying scenarios, the TCFD recommends using a range of scenarios that enlighten participants on the future exposure to both transition and physical climate-related risks and opportunities, tailored to the industry, economic sector, and geographical location of the organisation’s value chain.

A key scenario recommended by the Task Force is business-as-usual, which is critical for identifying the likelihood of physical risks (e.g. water scarcity, land degradation, flooding, extreme weather events), their magnitude and the necessary adaptation measures. This scenario will assist organisations with understanding the physical impacts from acute and chronic weather events which will interrupt businesses and operations across the supply chain.

Another key scenario which the Task Force recommends is a scenario which is consistent with keeping global warming below 2oC. This scenario assesses transition risks and its impacts under the assumption of meeting the science-based targets (SBT), in alignment with agreed international climate change commitments. This scenario will assist organisations to identify reduction targets and measures required for transitioning into a low-carbon economy. For information on SBT, please refer to https://paiaconsulting.com.sg/science-based-targets/

The typical categories of transition risks and/or opportunities an organisation should consider when applying scenario analysis are summarized in the table below:

Market and Technology Policy and Legal Reputation
As markets respond to climate change, supply and demand will shift for certain products and services. For example, reduced market demand for higher carbon products/commodities, and increased demand for energy-efficient, lower carbon products and services.

Organisations may also be impacted by improvements in technology, including technology that accelerates the transition to a lower-carbon economy. These new technologies will disrupt and displace parts of the current system.

How will these changes impact the financial security of investments? And what should key decision makers do to mitigate these disruptions?

International, national and state level legislations are evolving in response to the need for mitigation of climate change and to catalyse climate change adaptation. Organisations that fail to change are at risk of non-compliance.

For example, there is an increased threat to securing license to operate for high-carbon activities, and an increased risk of legal action against companies that have contributed to the causes of climate change.

Secondly, with the introduction of policies on pricing externalities (e.g. carbon tax), there is also an emerging concern about increased operating costs.

Stakeholders such as investors, lenders, and consumers are increasingly expecting responsible conduct from businesses. Failure to appropriately demonstrate adaptation risks loss of trust and confidence in management.

A client case study

In 2018, Paia Consulting was commissioned by a South East Asian client in the financial sector to conduct focus-group discussions (FGD) with a broad range of stakeholders, including senior management, representatives from all business units, and key external stakeholders.

The objective of the discussion is to solicit feedback from key internal and external stakeholders on the organisation’s sustainability strategy, materiality, and potential focus areas.

As part of the FGD, Paia applied the scenario analysis approach and presented two scenarios highlighting

  • physical risks from a business-as-usual approach, and
  • transition risks from government legislations and policies in meeting the national climate change commitments, i.e. the Intended Nationally Determined Contributions (INDC) under the Paris Agreement.

During the scenario analysis exercise, participants were asked to discuss and identify the effects of the scenario on the organisation, the organisation’s response to improve its resiliency, and initiatives which can be undertaken to achieve a different outcome or to thrive in these changing environments.

As a result of this scenario analysis exercise, participants were able to grasp and consider the multi-faceted ESG risks which can affect their organisation, and suggested potential solutions the company should develop to overcome key ESG risks.

[1] Global Climate Index 2017, Asset Owners Disclosure Project.

[2] https://www.blackrock.com/corporate/literature/press-release/1q-earnings-2018.pdf

[3] https://www.blackrock.com/corporate/about-us/investment-stewardship/voting-guidelines-reports-position-papers#2018-priorities