TCFD guidelines recommend stress testing the resilience of corporate strategy against different climate scenarios. In practice this is easier said than done.
The Taskforce for Climate-related Financial Disclosures , an initiative of the global Financial Stability Board, has established as the de facto global standard for corporate disclosures about the impacts of climate change. While it’s certainly an improvement to have guidelines, one of the more difficult aspects to operationalise is the development and application of future “climate scenarios.”
Another issue is that, while various supra national organisations are beginning to publish descriptions and assumptions for potential scenarios that could be adopted, they tend to deal with impacts at a decidedly macro-economic level: implications for GDP and other high level metrics. Unpacking that into micro-economic implications for a particular company (or even an industry) involves a multiplicity of assumptions.
To make matters worse, the economic modelling makes use of integrated assessment models, which authors of scenarios, such as the Network for Greening the Financial System (a global group of central banks) admit are either producing wide ranges of potential outcomes for a given scenario, or are under-estimating likely impacts, potentially by a wide margin . Both of which makes there usefulness at the corporate coal face somewhat compromised.
So what to do?
Each climate scenario needs to articulate two sets of assumptions across short, medium and long time horizons:
1. What is likely to happen to the climate (physical)?
2. How are governments, consumers, the economy, society, competitors, etc. likely to respond (transition)?
Applying those assumptions can then yield specific risks to a particular organisation. Typically (though not necessarily in a linear fashion), the likelihood and in some cases the impact of physical risks, such as asset damage or supply chain disruption due to extreme weather, will increase over time as global heating and its associated effects worsen. To the extent that countries collectively achieve or don’t achieve the emissions reduction targets inherent in the objectives of the Paris agreement, and within what time frames, will dictate the severity of the physical risk. Projected regional impacts based on climate models have been published over various time horizons and emissions reduction trajectories to inform scenarios.
Transition risks follow a less certain path and are dependent on the collective actions of governments, companies and individuals. The extent to which they affect a particular business (negatively or positively) depends on what that business does, how and where it sources, manufactures and sells its products or services, and what strategies it adopts with regard to climate risk.
However, a company that decides to switch to a low emissions path could be penalised if local government policy and customer sentiment is not aligned, particularly if its products are not cost competitive with incumbent alternatives or close substitutes.
This phenomenon can be seen most clearly with electric vehicles. When charged from renewably generated electricity they have no operational emissions, and no tail pipe pollution. In markets where government and popular opinion have embraced them, such as Sweden, uptake has been rapid despite the initial cost premium and perceived disadvantages such as range anxiety and the time it takes to charge, achieving over a quarter of new car sales by early 2020 .
In Australia on the other hand, where governments have actively resisted their uptake and fanned negative consumer sentiment by stressing their disadvantages , penetration has been tiny, with less than 0.5% of new car sales being electric models .
Defining climate scenarios with sufficent clarity to assess the sensitivity of a particular company’s P&L requires a clear process of considering, documenting and testing a range of macro and micro-economic, government policy and social assumptions (overlaid with regional climate projections relevant to the company’s sourcing, operating and market locations), within a broad scenario definition (such as implications of achieving a global heating limit consistent with the Paris Agreement, or exceeding that).
Suffice to say, whatever assumptions are made will most likely not materialise as expected. However, the strength of the scenario planning exercise is to help the organisation consider contingencies that may fundamentally change its operating environment and its customers’ appetite for its products. The bottom line is that the world is, quite literally, changing. More than ever before, past trends are no guarantee of future conditions.
As such, climate scenario planning should be seen as a process of continuous improvement, not a one off workshop. Leading companies are embedding climate considerations into day to day decision-making, striving to improve the analysis behind their scenario assumptions, and continually assessing the rapid shifts that are taking place.
Talk to Adaptive Capability today to understand the risks and opportunities of climate change to your business.