Scenarios
A New Approach To Climate Change Scenarios
The problem
Investors use scenario analysis due to the complexities involved in forecasting the effects of climate change. Recent studies demonstrate that current approaches to scenario analysis are not fit-for-purpose.
We propose actions that investors can and should take.
We propose actions that investors can and should take.
Recent studies published by financial think tank Carbon Tracker and University of Exeter present evidence that the current approach to scenario analysis has “seriously underestimated the economic dangers of climate change”.
The reports, published in July 2023, find significant disconnect between the climate science and the economics that informs the scenarios. This impacts and undermines the underlying models and methodologies used to create forward looking scenario analysis.
There are a number of themes that flow through both studies
The current approach to scenario testing has "seriously underestimated the economic dangers of climate change"
Scenario Analysis:
- Ignores environmental tipping points
- Does not account for the systemic risks of climate change
- Predicts the future financial effects of climate change based on the historic financial effects of climate change
- Tends not to assess the more extreme end of the warming scenarios – underplaying the consequences of the high warming scenarios
Our Thoughts
Broader Issues
We believe that the challenges associated with scenario testing are indicative of broader concerns with responsible investment:
Systemic issues overlooked
"ESG" is typically considered a company specific consideration. The portfolio effects of systemic ESG issues are largely misunderstood and mispriced.
Safety in numbers
There is a prevailing sentiment that it safer to fail conventionally than try to succeed unconventionally. ""Safer", well-established, investment strategies are often pursue at the expense of driving real-world change.
Focus on the wrong areas
Resource and bandwidth across the industry is stretched. Resources are often focused on 'business critical' areas such as regulatory and voluntary disclosure requirements - at the expense of research, implementation and stewardship.
A Fresh Start
To be clear – we are not discrediting or undermining past work. We are in the position we are thanks to the work so far and huge progress has been made from a standing start.
Rather it is a call to action to challenge convention when convention isn’t working. To use this opportunity to improve, not just scenarios, but ESG metrics and reporting too.
This year, many UK pension funds have, or will be, preparing TCFD reports for the first time. The International Sustainability Standards Board (ISSB), backed by regulators, has codified TCFD reporting in corporate and investor disclosures.
If the purpose of scenario analysis is to better understand climate change risks and opportunities then a fresh approach to scenarios is needed.
The reports put forward recommendations which we endorse. We wanted to add a few ideas of our own.
Is There A New Approach?
Deeper focus on the companies that matter
Traditional approaches to evaluating climate change risk frequently underestimate the pivotal influence of individual companies. It's not about overarching patterns; certain companies can either be major causes of environmental degradation or find themselves on the front-line of climate change impact. In our scenario testing, we advocate for a meticulous, evidence-driven evaluation of these influential companies, rather than a generalised overview of a portfolio. We believe this leads to more actionable data sets.
Incorporate environmental tipping points
Tipping points will lead to dramatic shifts, from food supply chains to widespread migrations, profoundly affecting businesses and portfolios. While pinpointing the precise effects would be highly challenging and complex, science can provide us with an understanding of the types of impacts that these tipping points could have and the potential timelines; factoring the most impactful into scenario testing can help users assess downside outcomes
Embrace a systemic approach to risk assessment
While individual company analysis is crucial (see 1 above), the integrated nature of our economy cannot continue to be overlooked (the effect that individual companies have on the rest of the portfolio). Future economic impact is currently assessed using bottom-up methodologies that often don't include holistic risks. We advocate setting a top-down scenario impact (e.g. 30% impact to GDP) more in-line with scientific literature and subsequently assessing how this will flow through to different industries and companies.
Incorporating environmental tipping points
Tipping points will lead to dramatic shifts, from food supply chains to widespread migrations, profoundly affecting businesses and portfolios. While pinpointing the precise effects would be highly challenging and complex, science can provide us with an understanding of the types of impacts that these tipping points could have and the potential timelines; factoring the most impactful into scenario testing can help users assess downside outcomes
Elevate the role of stewardship
While stewardship is common practice, the depth and impact of stewardship often falls short. Investors can of course divest companies that fail to transition, but climate change affects the entire system and many companies within portfolios will remain vulnerable. We believe proactive, data-driven stewardship, backed by informed scenario analysis, is the right set of tools to drive real world sustainability impact and make sustainability meaningful.
An Example
Tipping points identified and assessed
Use of scientific literature to identify and assess the broad impact of potential near-term tipping points. For example - further degradation of the Amazon rainforest is expected to lead to disruption of weather cycles, loss of biodiversity and significant impact on global supply chains