Climate change is upon us, and businesses must prepare for the future—and for climate risk reporting. Scenario analysis and planning will help.
Climate change presents companies with many unknowns, and they challenge a business leader’s ability to plan well for the future. But investors are now demanding that businesses develop a better understanding of how climate change can impact their operations and outlook, so they can make better-informed investment decisions.
The Task Force on Climate-Related Financial Disclosures (TCFD) has been instrumental in helping companies think about climate change in relation to their business. It highlights scenario analysis as a useful method for developing strategic plans that can accommodate possible future states and address climate-related risks and opportunities. Scenario analysis also informs stakeholders about how the business is preparing for these risks and opportunities.
A scenario essentially highlights elements of hypothetical events that are outside the norm, so business leaders can prepare for them. For scenario analysis, the TCFD advises businesses to examine at least two plausible scenarios, to compare the different outcomes and the corresponding physical and transitional risks.
To assist the private sector in scenario analysis, the Intergovernmental Panel on Climate Change (IPCC) has developed several scenarios. One of them is the 1.5° C scenario, in which global warming is capped at 1.5° Celsius above pre-industrial levels. In another, more extreme scenario, global warming exceeds 4° Celsius. But before we explore these scenarios, let’s look at the TCFD’s guidelines for scenario analysis.
A Framework for Scenario Analysis
Scenario analysis helps businesses think more strategically and explore alternatives in preparation for a future that may look very different. The TCFD’s scenario analysis criteria help companies create useful scenarios.
- The event(s) should be plausible and the narrative around the event should be credible.
- Each scenario should feature different combinations of key factors.
- Scenarios should differ in their structure and message.
- Multiple scenarios should be used to look at how different permutations and/or temporal developments can lead to different outcomes.
- Each scenario should be based on strong internal logic.
- Scenario analysis should look at how factors interact, and each action should have a reaction.
- Evidence of current trends and positions should not be overturned by actors or external factors unless logical explanations for those changes are a central part of the scenario.
- Each scenario, and the set of scenarios taken as a whole, should provide insights into the future that relate to strategic and/or financial implications of climate-related risks and opportunities.
- Scenarios should challenge conventional wisdom and simplistic assumptions about the future.
- When considering major sources of uncertainty, scenarios should try to explore alternatives that will alter the basis for business-as-usual assumptions.
The TCFD encourages businesses to think about their exposure under scenarios that include physical risks, like floods, and transitional risks, such as changing markets.
A Look at the IPCC’s Scenarios
Physical climate information looks at how the climate responds to the interplay between human influence, natural drivers and internal variability. Through its reports, the IPCC presents physical climate information to provide a data foundation and a baseline for climate risk reporting.
In a 2021 IPCC report that forms part of the IPCC’s Sixth Assessment Report, five climate change scenarios are presented. They rely on different climate warming trajectories that incorporate varying levels of carbon dioxide and non-carbon-dioxide greenhouse gas emissions, as well as aerosols and land use, along with their associated risks. The scenarios are based on Shared Socio-economic Pathways (SSPs), and socio-economic storylines are part of the scenarios. The IPCC’s five scenarios are:
1. The Paris Agreement’s 1.5°C goal (SSP1-1.9). Under this scenario, global warming is capped at 1.5°C, in line with the Paris Agreement goal. This is seen as a best-case scenario.
2. Sustainable pathways (SSP1-2.6). This mildly optimistic scenario shows lower GHG emissions, with global carbon dioxide emissions reaching net zero shortly after the mid-century mark. Global warming would be capped at 1.8°C and stabilize by 2100.
3. Middle-of-the-road development (SSP2-4.5). This scenario maps out a storyline in which carbon dioxide emissions remain at current levels until about 2050, but do not reach net zero by 2100. Under this scenario, global temperatures increase 2.7°C by the end of the century, and we see slow progress toward sustainability but little to no socioeconomic progress.
4. Regional rivalry (SSP3-7.0). This scenario shows carbon dioxide emissions that double (from current levels) by the end of the century. As its name suggests, this scenario shows a world in which countries must compete over resources to survive.
5. Fossil fuel-rich development (SSP5-8.5). In this worst-case scenario, global temperatures would rise by 4.4°C by the end of the century. And carbon dioxide emissions would be double their current levels by 2050.
The IPCC scenarios are intended to help organizations understand the impacts of increasingly severe climate change scenarios on our communities, ecosystems and biodiversity.
Additional Tools to Assess Climate Risks
Additional tools exist to help companies assess physical climate risks:
- The Climate Change Knowledge Portal (World Bank Group) offers climate-related data and tools to analyze climate change at national, subnational and watershed levels.
- ThinkHazard! (Global Facility for Disaster Reduction and Recovery) helps businesses assess the impact of potential disasters on new development projects, to promote more sustainable planning and design.
- Water Risk Filter (WWF) helps companies and investors assess and respond to water risks based on location and sector.
- Aqueduct Water Risk Atlas (World Resources Institute) is an open-source, peer-reviewed mapping tool for regional water risks, including floods and droughts.
- World Energy Outlook (International Energy Agency) uses rigorous modeling and the latest data to create long-term scenarios that illustrate the climate-risks, trade-offs and benefits of various courses of action.
TCFD guidance and the range of tools available will help businesses with scenario analysis and planning. As this will ultimately support their compliance efforts, there’s no better time than the present to start applying these recommendations and tools.
For more information on climate risk reporting, watch our webinar Getting Ready for Mandatory Climate Risk Reporting.