Tackling the Wicked Strategy Problem of our Time

Posted on 11/20/20 12:52 PM

Climate Scenario Analysis and the Climanomics®️ Platform Approach

Recently the Task Force on Climate-related Financial Disclosures published its 2020 Status Report. The document is a stunning testament to the popularity of the TCFD reporting framework and the growth of its adoption.

Over the past 15 months, the number of organizations expressing support for the TCFD has grown by more than 85%, reaching over 1,500 organizations globally, including over 1,340 companies with a market capitalization of $12.6 trillion. Concurrently, investor demand for companies to report information in line with the TCFD recommendation has also grown dramatically. In addition, more than 110 regulators and governmental entities from around the world support the TCFD, including the governments of Belgium, Canada, Chile, France, Japan, New Zealand, Sweden, and the United Kingdom.

But with this growth comes increased urgency for consistency and comparability in climate risk reporting, and the report outlines significant challenges that remain. These include the lack of reporting among smaller companies, the challenge of translating climate impacts into financial terms, and the fact that resilience strategy reporting is lacking.

Conducting scenario analysis is chief among the challenges facing companies on the road to TCFD reporting. As stated in the recent Climate Financial Risk Forum (CFRF; an entity established by Britain’s Prudential Regulation Authority and the Financial Conduct Authority) “…scenario analysis [is] one of the most challenging aspects of meeting supervisory expectations.” 

The reasons for this include the sheer complexity of the modeling associated with comprehensive climate scenario analysis. Other reasons outlined in the TCFD report include difficulty developing relevant scenarios that are decision-useful in a business context; gaps in the availability of business-relevant data and tools to support scenario analysis; challenges in quantifying risks, opportunities, and related financial implications; challenges associated with characterizing strategy resilience; and concerns about disclosing forward-looking scenario analysis involving confidential information.

Despite the challenges, comprehensive scenario analysis remains one of the most powerful tools at our disposal to begin unraveling and understanding the complexity of climate change and its potential impacts on communities, companies, and markets. As the TCFD report puts it: Scenario analysis serves companies well in the context of climate change, which is often termed a ‘wicked strategy problem’ imbued with a great deal of uncertainty.” 

To provide additional support to companies, the TCFD’s report included in-depth guidance on scenario analysis. The following article draws from this guidance, provides background on scenario analysis as a discipline, and breaks down some of the most important components of the TCFD guidance, addressing them through the lens of our work and the way the Climanomics®️ platform—software that enables reporting consistent with the TCFD framework—operates.

 

What is Climate Scenario Analysis?

Scenario analysis helps companies make strategic and risk management decisions under complex and uncertain conditions such as climate change. It allows a company to comprehend risks and uncertainties it may face under different hypothetical futures, and how those futures may impact its performance. The CFRF guidance explains: 

“A scenario is an alternative state of the world, typically centered on a narrative that brings it to life and helps to specify its inner logic. It is not a model, although models may be used to determine some of its characteristics…[it] is not a prediction, although it should be plausible whilst challenging business-as-usual assumptions…In the context of climate change, the TCFD recommends the use of climate scenario analysis to help firms explore the potential range of climate-related outcomes and analyze the impact of these alternative states of the world on the business in a structured manner, as well as how the business may respond in these circumstances.”

The TCFD 2020 report outlines the following points vis-a-vis scenario analysis:

  • The concept is not new. Scenario analysis has a long-established track record as a planning tool with a rich and extensive literature and practice.
  • It informs strategic management in a structured, systematic, and analytical way, providing a new perspective, clarifies the predictable and uncertain elements in different futures, and reorients decision-makers’ mental models.
  • It identifies options to address different climate-related circumstances, enabling companies to “road-test” different strategy options, and provide a lens through which to assess a company’s strategic positioning.
  • It is the cornerstone of developing resilience in that it allows for the continual exploration of alternative strategies; it can identify key drivers of change and pathways of development that a company can monitor to understand which futures are emerging and allow for “midcourse corrections.” 
  • Scenario analysis is used beyond climate issues and applies to a wide range of issues facing companies (e.g., the COVID-19 pandemic). Scenario analysis should be an integral part of a company’s decision-making process.

Finally, scenario analysis is not a standalone function but is supportive of overall strategy, governance, and risk management. When it comes to climate scenario analysis, the following (in italics) are excerpts from the 2020 TCFD Guidance that outline areas of strategic importance. We complement these excerpts with associated commentary detailing their relevance and relationship to our approach and how the Climanomics®️ platform functions.

 

1. Type of Scenario Analysis

“The two main types of scenario analysis are exploratory scenarios used to explore a range of different possible futures and normative scenarios used to plan for a preferred future….TCFD Strategy recommendation and this guidance focus on the use of an exploratory approach (i.e. a company assessing a range of scenarios spanning a number of plausible futures)...Typical climate-related scenarios are based on a targeted temperature outcome, with a corresponding set of underlying explicit or implicit emissions, energy, policy, and/or technology assumptions. This is how IPCC (Intergovernmental Panel on Climate Change) scenarios are constructed.”

The Climanomics®️ platform takes an exploratory approach, assessing plausible futures, by employing the Representative Concentration Pathways (RCPs) to develop multiple climate scenarios of any point on the planet. The RCPs were developed by the Intergovernmental Panel on Climate Change (IPCC) scientists to model the amount of atmospheric warming expected by the end of the century (measured as radiative forcing). The scenarios show four potential pathways, illustrated below, dependent upon the level of greenhouse gas (GHG) emitted as time goes on.

RCPs-Climate Scenarios

 

2. Sourcing Scenario Data

“[Companies can employ] either existing publicly available scenarios or develop their own. Each approach has benefits and drawbacks…[Drawbacks of public scenarios include that they are] developed for research and policy purposes, not company-level or sector-level analysis of climate-related risks and opportunities ...Drawbacks of propriety scenarios is that external stakeholders, such as investors, tend to consider in-house bespoke scenarios to be less transparent and less comparable than public scenarios.”

As mentioned above, to ensure accuracy and transparency, the Climanomics®️ platform employs the publicly available Representative Concentration Pathways (RCPs). Inputs include terabytes of climate and socioeconomic data on hazards from public (including IPCC, NASA, NOAA), academic and commercial sources, and proprietary TCS models. The rapidly growing TCS library of impact functions, modeling the vulnerability of individual assets to individual climate-related risks, is a key differentiator among climate risk providers. Inputs are updated frequently as new sources become available or desirable.

To ensure relevancy to the company employing the analysis, the platform pairs downscaled climate data with asset-specific data (property type, property value, location, emissions) derived from the customer that varies based on the strategic questions a company wants to answer. The data can be specific to certain portfolios, properties, trade routes, human capital, and more. 

The importance of targeting corporate data that will produce actionable insights cannot be overstated and is addressed again later in this piece. The amount of data generated by companies, especially multinational ones, is virtually limitless. TCS supports customers by steering them towards the proper use of financial metrics and data analysis that will answer strategic climate questions, which is quickly becoming an expectation of the investment community: 

“Investors often see climate-related disclosure around strategy as important. One study, in a survey of 439 institutional investors with a likely high awareness of climate risk, found 51% of respondents believe that climate risk reporting is as important as traditional financial reporting, and almost one-third consider it to be more important….[questions investors like to see addressed include]:

  • How climate-related issues affect products and services;
  • How climate-related issues affect capital expenditures and capital allocation;
  • A company’s sensitivity to carbon pricing, if applicable;
  • The scenario used by a company to inform its strategy, and their associated time horizons; and
  • A company’s identified material climate-related risks and opportunities over the long and medium term.”

When actionable insights are pursued, the scenario analysis exercise plays a critical role. It broadens the views and considerations that go into strategic thinking and improves the strategic planning process to strengthen the resilience of a company's strategy.

 

3. Optimal Number of Scenarios

“Some companies undertaking scenario analysis for the first time begin with two scenarios, usually at opposite ends of temperature outcomes….The TCFD recommendations do not stipulate a suggested number of scenarios, but rather ask companies to disclose strategy resilience informed by different climate-related scenarios.”

The Climanomics® platform currently employs two scenario options, RCP 8.5 scenario (a high emissions scenario) and RCP4.5, or a scenario more in line with the Paris Agreement. We will be introducing additional scenarios into the platform in the coming months, but for now, we find that the two scenarios—and the significant differences between them—provide a strong foundation for a company beginning its scenario analysis journey.

“No matter the number used, the key principle is that the differences between scenarios are sufficiently great to capture the key impacts and uncertainties of the drivers a company has identified.”

 

4. Scenario Analysis Time Horizon

“A scenario is structured around a number of basic elements such as a scope of coverage, a time horizon, and the choice of the number of scenarios used...In setting climate-related scenario time horizons, companies should challenge their thinking about traditional planning horizons, which are often too short. Scenario time horizons are typically longer than many corporate planning horizons.” 

High-quality scenario analysis helps companies move beyond short-termism and instead, bridge to longer-term, strategic thinking. As such, our work with customers usually includes a short, medium, and long-term approach. For example, the customer may look at 2020-2030 to understand risks that are of concern right now. They may look at 2040-2050 to understand the strategic implications of today’s actions - e.g., by mid-century, physical hazards such as coastal flooding tend to be accelerating rapidly. And they can look out beyond mid-century - all the way to 2090-2100 if necessary - to provide a long-term perspective. Timelines such as these afford the fullest picture currently possible of risks anticipated throughout the operational life or holding period of their assets.

 

5. Risks Assessed

“Scenario analysis should be conducted in a coherent way across physical and transition climate-related risks. Analysis of these risks should not occur in silos. Companies run the risk that they miss important feedback effects from physical risk that may be crystallized into transition risk.

The Climanomics® platform assesses both physical and transition risks as well as opportunities. Under the RCP8.5 / high emissions scenario, the financial impacts of physical risks often become more dominant over the course of the century. However, under the RCP4.5, we routinely see certain transition risks eventually surpassing physical risks for many assets in terms of financial impacts. The resultant ‘dance’ that occurs between physical and transition risks over time underscores the importance of modeling, visualizing, and analyzing transition risk, physical risk, and opportunities simultaneously to obtain a full and accurate picture of financial impacts. 

 

6. Frequency of Climate Scenario Analysis

“Scenarios have a shelf life, so a process to periodically refresh and update them is needed. This ensures continued relevancy and efficacy to a company’s overall strategic planning process…. A climate-resilient strategy requires continual exploration of alternative strategies, even if the current strategy seems to be working fine. Managing strategy resilience involves ongoing monitoring, adaptation, and transformation actions to influence the three characteristics of resilience: resistance, recovery, and robustness.” 

For corporates, we recommend updating analysis annually. For investors, more regular updates—quarterly or as triggered by deals or due diligence—are necessary given the strategic need for this data when making investment decisions. Overall, scenarios are most effective when integrated into a company’s regular planning and risk management processes and cycles, as well as corporate reporting processes. 

Particularly pertinent to current events is the TCFD’s comment on so-called “signpost metrics.” 

“Managing for resilient strategies requires adaptive probing—a continual exploration of alternative strategies, even if the current strategies seem to be working fine. This means periodic refreshment of a company’s scenario analysis, regular monitoring of the key indicators and signposts of the external environment, and adjustments when necessary…. One type of metric—signpost metrics—is particularly important in scenario analysis. Signposts help to monitor what scenario the world might be moving toward, as well as strategic options that might be increasing in value. Signpost metrics are indicators of which key drivers and scenario development pathways remain consistent with assumptions or are deviating toward a different outcome. Signposts may involve such things as important trends, events, or dynamics that determine scenario pathways, or junctures in pathways, where uncertainties may indicate a critical threshold around the pathway direction.”

The outcome of the US elections will undoubtedly be viewed as a signpost by many in the sustainability community. Biden’s stated focus on climate change, reports that he is considering a new White House Office on Climate Change as well as significant investment in the sector, will trigger a revisiting of scenario analysis in an array of companies and industries in the United States and throughout the world. 

 

Scenario Analysis Should Produce Actionable Information

The goals of scenario analysis vary by company, industry, and business area. Scenario analysis can help build answers to myriad questions; these include ‘how might property values be impacted in certain markets or rental markets?’ ‘What costs (insurance, a carbon tax, etc.) may arise, and can  be passed to clients/consumers?’ ‘How might trade routes and supply chains be impacted by sea-level rise or extreme weather?’ ‘How might human capital and productivity be impacted by conditions such as extreme heat?’ 

Developing quantitative climate scenario analysis will highlight the importance of action. The CFRF guidance on the topic begins with recommendations for a staged approach. The recommended steps include mapping a firm’s objectives, planning resources, assessing data providers, and defining how impacts can be translated into both financial terms and tangible action. According to the TCFD 2020 report:

“A company might start with broad questions such as How might our identified climate-related risks and opportunities plausibly affect our [company, business unit, product, commodity input, customer segment] over [specify time horizon]? What should we do? When should we take action? These broad questions can be further refined to focus on the relevant decisions and uncertainties around the climate-related risks and opportunities of most concern to the company.

 

The Value of Asset-Level Modeling

Once strategic questions are posed, the next step in developing scenario analysis is asset-level modeling. Only through granular analysis can an organization or investor identify the assets most in need of immediate investment. Asset-level analysis is especially critical for companies in possession of—or invested in—hundreds or thousands of diverse assets globally; in such cases, building a resilience strategy is an otherwise daunting task. 

When conducting this asset-level analysis across a portfolio of assets, we find the majority of the users of the TCS Climanomics® platform uncover that most of their climate risk resides in a small number of assets (otherwise known as the Pareto Principle—named for economist Vilfredo Pareto, the Principle suggests that roughly 80% of effects come from 20% of causes). This result may be due to the vulnerability of asset location, asset type, or asset’s lack of adaptive capacity. This information is critically important for decision-making and resilience-building; it empowers companies to prioritize assets for which investments in adaptation or resilience efforts will have the greatest risk mitigation benefits.

This graphic illustrates an anonymized example of this effect. It represents the risk by asset location from climate change in millions of U.S. dollars. The underlying models consider the value of a property, hazard risks such as flooding, wildfire, and extreme heat, and vulnerability of each asset to each of those hazards.

80-20 Rule-Investments

Managing and mitigating climate risk and building resilience can be a huge endeavor— from retrofitting buildings and implementing design improvements to moving power lines underground and upgrading water systems. Asset-level analysis can help companies identify priority areas for work that will maximize equitable resilience and provide significant returns on investment beyond company boundaries.

 

Conclusion

Fundamentally, climate scenario analysis can be an effective and valuable risk mitigation tool at a time of increasing, unexpected/unaccounted for impacts from extreme weather and other climate change impacts. The United States’ California fire season, which has grown in intensity and duration for years, provides a real-world example of climate change activity producing measurable financial risk. Faced with $30 billion in liabilities and over 700 lawsuits, PG&E Corporation filed for Chapter 11 bankruptcy protection after several mega-fires erupted in California leaving the utility unable to meet its financial obligations. More recently, the 2020 Glass Fire impacted 23 Napa Valley wineries through the decimation of vineyards, buildings, and inventory—the total cost to the vineyards is currently estimated in the hundreds of millions

As well as risk mitigation, climate scenario analysis is a powerful tool for competitive advantage. Based on the International Finance Corporation’s Climate Investment Opportunities in Emerging Markets Analysis, an estimated $23 trillion in climate-smart investment opportunities exist in emerging markets including green buildings, sustainable transport, renewables, climate-resilient infrastructure, and clean energy. The recent outcome of the US election may spur an even greater focus on sustainable investment and the development of business opportunities for financing climate change mitigation and adaptation.

Scenario analysis performed by the Climanomics® platform helps companies identify climate-related financial risks and opportunities, guides corporate strategy, and provides insight into how a company may perform under different, potential future states. The value of climate risk assessment has never been more clear both in terms of affording competitive advantage as well as in meeting fiduciary duty. The time to consider and measure climate risk is now.

 

Topics: Insights

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