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

This leads to perverse results, with (often, expensive to prepare) TCFD reports concluding that higher warming scenarios are financially better for savers; which, of course, is nonsense. The Carbon Tracker report claims that, rather than challenging the advice, pension trustees are accepting it as the best available and, understandably, relying on the view of their advisors. Meanwhile, data providers have rushed to prepare new ways of presenting the same data in different formats, such as temperature models.

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

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

Portfolio heatmap from multiple scenarios

Run multiple scenarios to build an understanding of portfolio risk using a heatmap to identify companies with consistent risk exposure. For example. a high-emitting company using commodities from the Amazon with a coastal distribution network may stand to lose significantly in multiple scenarios.

Direct and systemic impact to portfolio

Deep dive on companies with direct exposure to Amazon degradation - for example those in primary industries with parts of their value chain dependent on the Amazon together with understanding the systemic risk from the changing climate and use of carbon budget. Assume significant global GDP impact from environmental change and map to industries and sectors most likely to lose.

Use heatmap and data to drive stewardship

The scenario analysis enables investors to engage with companies that present high risk using data and scientifically-linked process. We overlay financial performance to provide investors with fully-informed flexibility and insight when making strategic decisions in respect to their portfolio.

Why work with Canbury

Canbury was created with a vision to make sustainability meaningful. Drawing on a unique blend of financial and sustainability experience, we partner with investors, companies and NGOs to develop investment industry guidance, to undertake thematic research and to interpret financial regulation. Our founders, Will Martindale and Ben Wilmot, bring over two decades of financial sector, pensions and sustainability experience. We have deep expertise in preparing TCFD reports for companies and investors, including those with complex investment strategies or asset classes with hard-toreach GHG emissions metrics. Our experience allows us to challenge convention – when convention isn’t working. Scenario analysis is not fit for-purpose. This is a shared problem – and one we can support you to solve.