Climate Scenario Analysis - Understanding how climate change and the energy transition could affect companies, sectors and markets

Introduction

Climate change poses significant risks to the global economy, considering its profound influence on the stability of both the financial system and natural and social environments. However, predicting future climate patterns remains a challenge due to their dependence on uncertain factors such as population growth, the use of carbon fuel as an energy source, technological development, policy changes, etc. Therefore, climate scenario analysis emerges as a structured approach to assess the potential impacts of climate change.

What is climate scenario analysis?

Climate scenario analysis is the process of using specialized climate science models to explore a variety of plausible futures across climate impacts and time horizons to help understand a wide range of risks and opportunities. It is not a climate prediction, nor does it assess the likelihood of future events occurring.

What challenges does it address?

A quantitative approach can yield new insights and potentially turn risks into opportunities by addressing the following challenges:

• The time horizons of counterparty exposure often varies significantly from climate impact timescales.
• Climate science and decarbonation technologies are constantly evolving.
• Relating non-financial factors, such as greenhouse gas emissions, directly to financial outcomes can be challenging.

Use cases

One workflow, several applications

• Climate Stress Testing – Financial institutions can assess the impact of climate risk on significant exposures using ‘stressed’ scenarios. This allows them to meet requirements on climate stress testing submissions to regulators, who use the results to identify climate related systemic risks in the financial system.
• Strategy Setting – A company can use the insights generated from multiple climate scenarios to guide its target-setting, strategy development, and transition planning process. This enables a holistic and more informed view on the transition and appropriate targets for each business line or sector.
• Sustainable Financing – Companies can employ climate scenario analysis and pledge transitions to identify financing gaps and assess capital requirements based on their financial profile. Engaging with customers to understand their strategies and support their transitions is essential to financing the right solutions (whether public or private financing) and enabling change in the real economy.
• Risk Management – Whether it’s loans, investments, supply chain or business operations, through a quantitative impact analysis, climate scenario analysis can inform all pillars of risk management including credit, market and operational risk. It can be used to review policies related to risk management and revise credit assessment frameworks.
• Reporting and Disclosures – As reporting frameworks such as ISSB, CSRD, GRI etc. are evolving globally, and demand for appropriate climate related financial disclosures is increasing, climate scenario analysis enables one to confidently analyze and report risks to stakeholders.

In this five-part series, we shall explore how climate scenario analysis can be applied to each of these use cases.

PART I: Climate Stress Testing

The use of climate stress tests to evaluate the vulnerability of financial institutions to climate change impacts is gaining momentum globally. As supervisory authorities, regulators, central banks, and policymakers aim to understand the financial risks posed by rising global temperatures, these exercises have become crucial in assessing systemic vulnerabilities.

Characteristics

A review by the United Nations Environment Programme – Finance Initiative (UNEP-FI) of 23 climate stress testing exercises -conducted by financial supervisors revealed that^[1]:

1. Scope - Most supervisory exercises have been targeted towards banks. Less than 30% of exercises focused on both banks and insurers. Only 4% of exercises focused on investment funds, banks, and insurers together, as well as just insurers.
2. Scenarios - Most climate stress testing exercises have used the scenarios by the Network for Greening the Financial System (NGFS). The most common scenario is the current policies scenario, followed by a delayed transition and a Net Zero 2050 scenario.

Table 1: Summary of climate transition scenarios^[2]

3. Types of Climate Risks - The components of climate risk included assessment of transition risk on corporate loans and assessment of physical risk on direct asset exposures. In some of the more recent exercises though, it was noted that a combination of both, transition and physical risk on corporate loans was expected as well.

4. Types of Financial Risks - 87% of climate stress tests have in some way examined climate impacts on credit risk. Some exercises also examine the impact of climate change on other financial risks such as market risk, reputational risk, operational risk, sovereign risk, insurance risk, liquidity risk, and financial stability risk, with the latter being part of a narrative portion to their exercises in the form of a qualitative questionnaire.

Figure 1: Transmission of Climate-related Risks to Financial Risks^[3]

5. Metrics - The most commonly employed risk metrics for evaluating risk and assessing changes in the financial stability of a company include the Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).

6. Approach - The exercises were grouped under two approaches: Bottom-up approach where financial institutions conduct analysis using the scenarios on individual counterparties where they have meaningful exposures and top-down which are less resource-intensive and conducted at a sector/portfolio level.

7. Horizon - While most typically adopted a 30-year time-horizon for their exercises. A growing number of supervisors have begun incorporating scenarios with shorter time horizons into their exercises. that align to the time horizons (i.e. two to five years) traditionally used at financial institutions for capital and strategic planning.

Challenges

1. Data Gaps - Financial institutions face difficulties in collecting the necessary ingredients for running transition and physical risk analysis. This includes emissions data (Scope 1, 2 and 3) and asset level locational data from their counterparties.

2. Lack of Standardization – Standard definitions and formats for reporting data are currently lacking, which adds to the complexities of using such data for stress test exercises.

3. Sector Characteristics – Sector specific nuances need to be embedded in the modeling approach; otherwise, the results of the stress tests will be too similar across sectors, and the impact may be understated in terms of both risks and opportunities.

4. Modeling Limitations - The long-term horizon of many climate stress testing exercises creates uncertainty in how emissions and climate risks will evolve over the period. These exercises also do not align with the tenor of the exposure, so internal models may need to be adapted.

5. Scenario Limitations – Additional granularity and down-scaling of data at the sector and country level are needed to reflect the local socio-economic dynamics in a particular jurisdiction.

Best practices for Financial Institutions

1. Select Scenarios - If it is a supervisory exercise, the supervisor would likely provide the scenarios. In the case of an internal exercise, external scenarios (e.g. NGFS scenarios) may be considered. Consider scenario expansion to fill gaps in the scenario variables by sourcing information from academic research or internal experts.

2. Build the Ingredients – Source a variety of datasets, including financial, environmental, asset-and industry-specific data, and transition pledges from internal databases, via a client questionnaire, or credible data providers such as S&P Global. Gaps may be filled using credible estimation methodologies.

3. Conduct Analysis - Link scenarios and datasets to possible financial outcomes by utilising the scenario pathways and their manifestation into key drivers of financial impact.

4. Use Output to Take Action – Use outputs to revise risk management policies, build capabilities and skills, inform target setting, set limits and engage with clients on adaptation and mitigation strategies.

5. Upskilling - Conduct workshops on the key learnings and challenges with the objective to upskill the relevant stakeholders within the business on the topic of climate change.

Case Study:

The case study below is an illustrative example of actionable insights can be gained by adopting the suggested best practices within the climate stress testing exercise. It represents an automotive manufacturing portfolio that consists of 10 corporates from Germany, United States, China, Korea and Japan.

Under the delayed transition scenario, given that policy implementation is initiated only after 2030, the average change in credit notches for the portfolio is almost the same under both, a static and adaptive assumption. However, the differentiation comes into play post 2030, with companies facing credit deterioration under the static approach, leading to higher costs and reduced demand for non-electric vehicle (EV) volumes of cars produced. In contrast, under the adaptive assumption, companies perform significantly better, as the benefits of the transition are seen across all drivers of financial impact, including price, volumes, costs and asset valuation.

Example 1: REMIND – Delayed transition scenario^[4]