Scenario Analysis
We don’t always know how or when climate change will affect businesses. Some are already seeing the impact, but for many others, the biggest changes are still to come. Because the future is uncertain, it can be hard for businesses to plan ahead. That’s why it’s important to explore different possible futures and think about how climate change might affect things like strategy, operations, and finances. One way to do this is by using scenario analysis.
Scenario analysis is a helpful way to plan for the future by thinking through different possible situations. It allows businesses to create strategies that can adapt or hold up well, even if things change.
It’s important for investors and others to understand how climate change might affect a business in the future. This includes how prepared the business is for both physical risks, like extreme weather, and transition risks, like new climate policies. That’s why the Task Force recommended that companies use scenario analysis to explore how these risks and opportunities could impact their business, strategy, and finances, and share those insights in their yearly financial reports when relevant.
Scenario analysis helps businesses think through what the future might look like in different situations, especially when there’s a lot of uncertainty. These scenarios aren’t predictions or exact forecasts. They are made-up examples that help organizations imagine how things could change. When it comes to climate change, scenario analysis lets a company explore how different climate risks, like new laws or extreme weather, could affect its business, plans, and finances over time.
Scenario analysis can be done in different ways. It can be qualitative, using narratives and descriptions, or quantitative, using numerical data and models. Sometimes, it’s a mix of both. Qualitative analysis is useful when there isn’t much data, and it helps explore possible patterns and ideas. Quantitative analysis works well when you have numerical data to work with, like trends you can measure. In both cases, the scenarios need to make sense, follow a clear logic, and be based on clear assumptions, so they show realistic paths the future could take.
There are several reasons why scenario analysis is a useful tool for organizations in assessing the potential implications of climate-related risks and opportunities.
It can help organizations consider issues, like climate change, that have the following characteristics:
possible outcomes that are highly uncertain e.g., the physical response of the climate and ecosystems to higher levels of GHG emissions in the atmosphere
outcomes that will play out over the medium to longer term e.g., timing, distribution, and mechanisms of the transition to a lower-carbon economy
potential disruptive effects that, due to uncertainty and complexity, are substantial
It can improve how organizations think about the future by helping them consider what could happen beyond the usual business routine. It encourages decision-makers to think more widely, exploring different possible scenarios, especially those where climate change might have a big impact.
It helps organizations think through how climate change could affect their business, strategy, and finances. It also helps them consider what actions they might need to take in response. This kind of planning can lead to stronger, more flexible strategies that are better prepared for an uncertain future.
It can help organizations spot key signals in the outside world and recognize when things are changing in a way that fits a different scenario. This gives them a chance to reassess and adjust their strategies and financial plans as needed.
It helps investors see how strong an organization’s strategies and financial plans are, and it lets them compare risks and opportunities between different companies.
Since the effects of climate change on specific sectors, industries, and individual organizations are highly variable, organizations should consider applying a basic level of scenario analysis in their strategic planning and risk management processes. Organizations that are more affected by transition risks (like fossil fuel industries, energy-heavy manufacturers, and transportation) or physical risks (such as agriculture, infrastructure, insurance, and tourism) should think about using scenario analysis in more detail.
Transition risk scenarios are especially important for resource-heavy organizations with high greenhouse gas emissions in their supply chains. Changes in policies, technology, markets, or regulations aimed at reducing emissions, improving energy efficiency, or introducing taxes or subsidies could have a big impact on these businesses.
One important type of transition risk scenario is the 2°C scenario. This scenario outlines a path and emissions levels that would keep the global temperature rise to 2°C above pre-industrial levels, in line with the goals of the Paris Agreement. The 2°C scenario offers a shared reference point that aligns with the goals of the Paris Agreement. It helps investors assess the potential size and timing of transition-related impacts on individual organizations, sectors, and even across different industries.
Many organizations face climate-related physical risks. These scenarios are especially important for businesses that are vulnerable to short-term or long-term climate changes, such as those with:
long-lasting, fixed assets,
operations in climate-sensitive areas (like coastal or flood-prone regions),
dependence on water availability, and
supply chains affected by the factors above
Physical risk scenarios usually highlight extreme weather threats that are moderate or higher risk before 2030, with more types of physical risks expected between 2030 and 2050. While many climate models provide results for physical impacts beyond 2050, organizations typically focus on the effects of these risks over shorter periods that match the lifespan of their assets or liabilities, which can vary by sector and organization.
In their final report, the Task Force recommended that all organizations facing climate-related risks should:
use scenario analysis to guide their strategic and financial planning, and
disclose how well their strategies can handle a range of possible climate-related scenarios.
As much as for many organizations, scenario analysis would be largely a qualitative exercise, the Task Force recommended that organizations with significant exposure to transition and/or physical risks should conduct more detailed qualitative analysis and, if needed, quantitative analysis on the key factors that affect their operations.
An important part of scenario analysis is choosing several different scenarios, not just one. These should show a range of possible future outcomes, some positive and some negative. The Task Force advised organizations to include the 2°C scenario, along with two or three other scenarios that best fit their situation. These could include scenarios based on Nationally Determined Contributions (NDCs), physical climate risks, or other challenging possibilities. In places where NDCs are widely used to guide energy or emissions plans, they can be especially helpful as part of the scenarios an organization uses for climate-related analysis.
Nationally Determined Contributions (NDCs), are climate action plans submitted by each country under the Paris Agreement to reduce greenhouse gas emissions and adapt to climate change. An example is Ireland’s Climate Action Plan.
For organizations that are just starting to use scenario analysis or have limited experience with climate-related issues, the Task Force suggested sharing a general description of how well their strategy and financial plans might hold up under different climate change scenarios. This kind of information helps investors, lenders, insurers, and other stakeholders see how strong and flexible the organization’s plans are when facing different possible futures.
When disclosing key aspects of their scenario analysis, organizations with more significant exposure to climate-related issues should consider including the following details:
The scenarios used, including the 2°C or lower scenario
Critical input parameters, assumptions, and analytical choices for the scenarios used, including factors such as:
assumptions about possible technology responses and timing e.g., evolution of products/services, the technology used to produce them, and costs to implement,
assumptions made around potential differences in input parameters across regions, countries, asset locations, and/or markets
approximate sensitivities to key assumptions
Time frames used for scenarios, including short-, medium-, and long-term milestones e.g., how organizations consider timing of potential future implications under the scenarios used.
How the organization’s strategy might perform under different scenarios, including possible impacts on its value chain, investment choices, research and development priorities, and any important effects on financial results or financial position.
Organizations should use scenario analysis to understand climate-related risks and opportunities. For those just starting out, a basic, qualitative approach that improves over time may be suitable. Organizations with more experience may need to apply more detailed data, models, and analysis. They can choose to use external scenarios and tools from third parties or create their own models, depending on their needs, resources, and capabilities.
While conducting scenario analysis, organizations should strive to achieve:
transparency around parameters, assumptions, analytical approaches, and time frames;
comparability of results across different scenarios and analytical approaches;
adequate documentation for the methodology, assumptions, data sources, and analytics;
consistency of methodology year over year;
sound governance over scenario analysis conduct, validation, approval, and application; and
effective disclosure of scenario analysis that will inform and promote a constructive dialogue between investors and organizations on the range of potential impacts and resilience of the organization’s strategy under various plausible climate-related scenarios.