Climate Scenario Analysis - Important tool to understand your climate exposures



Background


Global temperatures have increased by over 1.2 °C. All actions are under tested, portfolio alignments are being adapted by bankers to test their portfolios’ climate resilience. A transition to a low-carbon economy entails a transition away from fossil-fuels reliance and investment in low-carbon technologies. It sets a direction for the current market climate and imposes great challenges for market participants and asset owners to assess their climate-related exposures.


TCFD Recommendations: “The Task Force considers scenario analysis as a useful tool for risk identification and assessment of climate-related risks and has been emphasising the importance of using scenario analysis to assess potential business, strategic, and financial implications of climate-related risks since the publication of the TCFD recommendations 2017.”


According to IPCC Scenario Process for AR5: “The goal of working with scenarios is not to predict the future but to better understand uncertainties and alternative futures, in order to consider how robust different decisions or options may be under a wide range of possible futures”.



Legal Compliance requirements


Rising legal requirements leads to concerns over climate scenario analysis. Besides that, taking climate risk assessment has been one of the most useful tools for decision-makers to factor climate risks into their decision making processes.


SFDR Requirements: Article 9 of the SFDR Draft RTS Requirements: References to international standards section, where a a forward-looking climate scenario was required:


"…(c) where a forward-looking climate scenario is used, an identification of that scenario, including the name and provider of the scenario and when it was designed; and (d) where a forward-looking climate scenario is not used, an explanation of why forward- looking climate scenarios are not considered to be relevant by the financial market participant. "


TCFD Recommendations


Because it is difficult to project future emissions and other human factors that influence climate, scientists use a range of scenarios with various assumptions about future economic, social, technological, and environmental conditions. Such scenarios have been very useful in helping scientists to investigate possible ramifications of global climate change and to policymakers in assessing mitigation and adaptation options. However, they often have limitations for assessing the business implications of climate change at a local or industry sector level. It is a part of the TCFD Recommendations for organisations to disclosure its governance around climate-related risks and opportunities.


Forward-Looking Strategic Planning



Lower transition risk is likely to result in higher levels of physical risk from climate change. Organisations, therefore, need to use scenarios that allow them to consider a range of potential transition and physical effects on their strategy and financial planning and how these effects compare to various publicly available scenarios and national goals. To achieve that, corporates shall disclosure the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses strategy, and financial planning where such information is material. (TCFD) More specifically:


  • Describe the climate-related risks and opportunities the organisation has identified over the short, medium, and long term.

  • Describe the impact of climate-related risks and opportunities on the organisation's businesses, strategy, and financial planning.

  • Describe the resilience of the organisation's strategy, taking into consideration difference climate-related scenarios, including a 2°C or lower scenario.



Leverage different blend of climate-related risk and opportunities


According to Botte F, Ciarli T, Foxon T, Jackson A, Jackson T and M Valente’s paper on Rebuilding Macroeconomics, to achieve net-zero requires a formidable transition from current market modes of running. It demands replacement of entire technologies, supply chains and infrastructures of provision (e.g. for energy, food, and transport) within a timescale considerably shorter than the average asset life associated with these sectors. Such replacement will require directed (or incentivised) investment at a scale that’s unthinkable at a scale typical of mature post-industrial economies. Market and consumer behaviour will entail widespread changes and organisations and policymakers are on the spot to adopt responsively or risk becoming vulnerable to the changing landscape.


Such technological change entrails great opportunities for organisations to profit from seeking better solutions for the business to have a chance in surviving and combating with climate change. Meanwhile, investors are looking to obtain increased exposure to companies engaged in the transition to a green economy. As FTSE Russell describes, the greening of the global economy—in response to the threat of climate change and other environmental challenges—presents myriad opportunities to investors.



Uncover data intelligence insights


Though Climate-related disclosures and ESG active disclosure volumes remains low. Data scientists and ESG data vendors are working on building different blend ESG data and alternative data solutions for businesses and investors to utilise potential data insights while meeting disclosure obligations. GC Insights study the challenges investors face in data demands and source the best quality ESG and alternative data and map to meet any given legal requirements for businesses and portfolios to uncover data insights when aligning climate strategies.



Risk management: climate-related risk assessment


There are typically four types of climate-related risk categories: they could be physical risks that are posed by the changing climate or direct impact from increasing climate-related damage or indirect interruption on business operation and supply chains.



Ongoing transition to low-carbon economy is helping to mitigate climate-related physical risks. Rising transition risks also challenging better understanding of uncertainties and alternative futures for wider range of possible future. The TCFD recommends organisations to disclose how the company identifies, assesses, and manages climate-related risks. It states the following recommendations:

  1. Describe the organisation's processes for identifying and assessing climate-related risks.

  2. Describe the organisation's processes for managing climate-related risks.

  3. Describe how processes for identifying, assessing, and managing climate-related risks are integrated into the organisation's overall risk management.


Furthermore, organisations should include scenario analysis as part of their strategic planning and/or enterprise risk management processes by:


  • Identifying and defining a range of scenarios, including a 2°C scenario, that provide a reasonable diversity of potential future climate states;

  • Evaluating the potential resiliency of their strategic plans to the range of scenarios; and

  • Using this assessment, identify options for increasing the organisation’s strategic and business resiliency to plausible climate-related risks and opportunities through adjustments to strategic and financial plans.

  • A list of key considerations including:



Challenges

As pointed out by the EFRAG (European Financial Advisory Group), there are variations in TCFD reporting and data challenges in performing climate scenario analysis. Unsymmetrical resources and exposures are making it difficult for users in different sectors and sizes (typically for SMEs and sectors with less exposures to the current centred topics in relevant material manners). This is typical for sectors with less carbon-intensive feature, however, even being outside of the current identified "centre issues", they could be consequential to the climate crisis one way or another. A sectoral guidance could be helpful, a tailored strategy is even better.


Uncertainties in technological changes, consumer behaviours and policy updates, etc. are clouding the current climate scenario analysis modelling, the models could only be as good as the feeding data sets. Comparability and consistency is keys to the next analysis and reporting, even at an early stage.


To mitigate and adapt to this new norm, GC Insights offers strategic planning in:






(written by Yitong Yuan)


To learn more about the topic, please request via: info@gc-insights.com



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