The growing uncertainty of climate change presents challenges to companies to understand its effects on their operations, business strategy, and financial performance. Climate Scenario Analysis enables a business to test the resilience of its operations against potential climate scenarios.
Climate-related scenarios enable an organization to explore and develop an understanding of how the physical and transition risks and opportunities associated with climate change might impact the business over time.
“Climate Scenarios aren’t forecasts, but data-driven narratives that help companies think through different possible futures.” – Mark Carney
What is a Scenario?
- A scenario describes a path of development leads to a particular outcome
- Scenarios are not intended to represent a complete description of the future, but represent a highlight of central elements of a possible future, and are intended to drive attention to key factors that will drive the future
- They are hypothetical constructs, not forecasts or predictions or sensitivity analyses
Scenarios need to represent plausible, distinctive, consistent, relevant, and challenging futures.
What is Scenario Analysis
- Scenario Analysis is a tool that can enhance strategic thinking of the future
- A key feature is that it challenges conventional thinking
- Scenarios help explore alternatives that challenge the business-as-usual assumptions
3 Steps of Climate Scenario Analysis
- Perform the Analysis – Define Scenarios
- Define and agree to the objectives of climate scenario analysis.
- Assess material climate risks
- Define range of scenarios – A key aspect of scenario analysis is the selection of scenarios.
- Define and implement governance
- Interpret Scenario Analysis
- Evaluate Business Impacts
- Identify potential responses
- Refresh scenarios
- Disclose Scenario Analysis
- Communicate analysis
- Apply learnings
- Best practices for disclosures to meet regulatory requirements and stakeholder needs.
TCFD Scenario Analysis Process
Defining Objectives
TCFD recommends that companies identify the focal questions they need to assess through climate scenario analysis. These are questions related to how climate change risks will impact the business.
Examples of questions organizations may need to answer are:
- Which perils will impact the business, and how will they manifest over time?
- What is the physical impact to assets and operations?
- What is our supply chain exposure and how will it translate to business interruptions?
- How can we improve resilience?
- How can we support and benefit from innovations in low-carbon technology? What investments do we need to make in research and infrastructure to support our goals?
- How will changes in policies impact our business?
- How will consumer demand change with time?
- What new revenue streams might be available in the low-carbon economy?
To identify the questions relevant to the business, companies should create a multi-disciplinary team of stakeholders, including members from risk management, legal, insurance, operations, finance, strategy, and procurement, and establish the governance process.
Assessing Material Climate Risks
Organizations need to understand the nature of climate-related risks they may face, as the impacts of climate change will vary significantly based on the sectors and locations of their business.
Some aspects to consider are:
- the geographic location of the organization’s value chain (both upstream and downstream);
- the organization’s assets and nature of operations;
- the structure and dynamics of the organization’s supply and demand markets;
- the organization’s customers; and
- the organization’s other key stakeholders.
Companies can quantify risks by measuring cash flow at risk, change in value for assets, and implications to capital costs and investments.
Choosing Climate-Related Scenarios
The International Energy Agency (IEA), the IPCC, and the NGFS have developed a range of scenarios that companies can use to select the scenarios relevant to their business. These scenarios are based on estimates of future population levels, economic activity, governance structure, social values, and technological change with inputs from climate scientists, economists, and other experts.
The image below shows the 7 Climate Scenarios published by the NGFS in November 2024.
Companies can also create bespoke in-house scenarios tailored to their specific risks and opportunities. TCFD recommends that companies revisit and refresh scenarios every 3-4 years.
Another consideration is the time horizon of the scenarios. Climate scenarios tend to be longer than average business planning time horizons, as too short time horizons might limit thinking to current trends. Organizations should consider time horizons that are: 1) compatible with the company’s capital planning and investment horizons, and the useful life of major company assets. and 2) in line with national and international policy communities (e.g., 2030 & 2050) to enhance comparability.
Evaluating Business Impacts
Business impacts can result from the risks and opportunities that affect business performance.
Climate change related risks can be categorized into physical and transition risks.
Physical Risks
- Acute Risks: Increased severity of weather events like floods, droughts, and fires.
- Chronic Risks: Rising mean temperatures, rising sea levels, change in weather patterns.
This can result in reduced revenue due to decreased product capacity, increased resource costs, transportation difficulties, supply chain disruptions, workforce impacts, and/or property damage.
Transition Risks
- Policy and legal risks
- Technology
- Market
- Reputation
Climate-related opportunities
- Resource efficiency
- Energy Source
- Products & Services
- Markets
- Resilience
Identifying Responses
Scenario Analysis forms the foundation of all 4 pillars of TCFD reporting and informs decisions in each pillar.
You can use the results of scenario analysis to identify applicable, realistic decisions to manage the identified risks and opportunities. What adjustments to strategic/financial plans would be needed?
The scenario analysis team should provide a strategy to plan and implement the responses to different scenario impacts. The strategy might include:
- Assets, products and services impacted by the scenario, including a financial quantification of the impact
- Potential actions required to mitigate the impact. Examples of action include moving facilities, purchasing renewable energy, creating new products, and creating a decarbonization strategy.
- List of resources required to act on the mitigation of the impacts
- Success factors, timeframes and tracking measures
- Prioritization of the actions
Disclosing Scenario Analysis
Specific regulations like SB 261 and stakeholders require companies to disclose the results and actions from scenario analysis.
Disclosures should include:
- Scenarios chosen – including the time horizon and the source of the scenarios
- Quantification of the business impact of the scenario
- The governance process for scenario analysis, including the role of the board, company leadership, and composition of the team
