To address limitations in scenario analysis, investors are likely to develop their own in-house models to fill sectoral and geographical data gaps.
Climate scenario analysis – deemed critical to understanding and mitigation of climate risks – is still in its very early stages, often lacking transparency and failing to account for key risks, investors have been warned.
A rapid rise in climate scenario analyses is being driven by increased investor demand and their use in major reporting standards like those developed by Task Force on Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB).
According to research by Sustainable Fitch, this proliferation means investors will increasingly be presented with climate scenario analysis as the basis for assessing transition and net zero plans of corporates. It will also become embedded into the engagement and stewardship programmes of financial institutions, including asset managers, with asset owners using it for portfolio-wide target setting and alignment with net-zero targets.
Climate scenario analysis is, however, still in its “infancy”, said Marina Petroleka, Global Head of Research at Sustainable Fitch, meaning that actioning the insights and outcomes can be a significant challenge for investors.
“Climate scenario analysis has limitations and is highly nuanced,” said Petroleka during a webinar, adding that even the smallest change of variables can produce different outcomes, which are then used to make potentially highly impactful investment decisions.
To counteract this, transparency is vital, she said.
“I have learned from this exercise to be careful with any climate scenario analysis that is presented as a black box or lacks details about methodologies, inputs, or interpretation of outputs.”
Implications and limitations
Climate scenarios have a range of use cases and are becoming key tool in climate risk management, according to Aurelia Britsch, Global Head of Climate Research at Sustainable Fitch.
However, the research conducted by Sustainable Fitch highlighted that climate scenario integrated assessment models (IAMs) have limitations, with several open to misinterpretation risks that can lead to the underestimation of climate risks for investors and the financial sector as a whole.
Birtsch stressed that the issue is not with the climate scenarios per se, but rather that their analytical limitations are often poorly understood by users, with investors and other financial market participants needing awareness of these limitations in order to interpret them correctly.
“There is a rising awareness among investors and even among scenario providers that current scenario models exclude or underestimate significant risks,” she said. “That’s because they are not able to fully incorporate a number of non-linear changes.”
According to Birtsch, these non-linear changes include climate change tipping points – critical thresholds that, once crossed, lead to larger, often irreversible changes to the climate system – such as permafrost loss, monsoon pattern shifts, and coral reef loss.
Other non-linear risks cannot be reliably modelled, such as geopolitical risks like war, and other unprecedented events like a new pandemic or an unexpected technological breakthrough. Further, a third non-linear trend that climate scenarios struggle to integrate is macroeconomic impacts, such as the boom-and-bust economic cycle which can affect climate policy momentum.
“As a result, conducting climate scenario analysis at the entity and financial system level could give some the false sense that the risk is being understood and measured if those underlying assumptions are not known and understood themselves,” said Birtsch.
Another limitation that investors need to consider, according to Birtsch, is the limited standardisation around climate scenario practices and the lack of transparency around the scenarios used, which make it difficult to compare results across entities.
“This limitation is more due to companies’ practices and disclosures and not really with the scenarios themselves,” she said, adding that a bottom-up analysis of climate risks based on individual entities in a climate scenario study is not “very accurate methodologically speaking”.
Amending ‘off-the-shelf’ scenarios
This is driven by a number of factors, such as the fact that there are large variations in scope and objectives of the different climate scenario analysis conducted by different entities, she said. For example, many banks use the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) scenarios; with it being the “go-to provider for financial institutions”.
In May, the NGFS announced that it plans to develop short-term climate scenarios to enhance its existing scenario framework, which primarily focuses on long-term climate projections. The introduction of short-term scenarios aims to capture the potential adverse effects of a disorderly transition and severe natural disasters in the near future.
According to Birtsch, large banks and investors are likely to increasingly develop their own in-house or bespoke climate scenarios by amending ‘off-the-shelf scenarios provided by external providers, including the Transition Pathway Initiative developed in collaboration with the Principles for Responsible Investment and FTSE Russell.
“The use of bespoke, in-house scenarios allows these institutions to fill in sectoral and geographical data gaps,” she said, adding that this enables users to tailor the scenarios to the specific business models of each entity or investor.