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Demystifying climate scenario analysis for financial stakeholders

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Scenario analysis is an essential yet challenging component of understanding and preparing for the impacts of climate change on assets, markets and economies. When focusing on the short term, the warming and related impacts we already have committed to calls for scenarios that are decoupled from economic and policy activities and instead focus on the impacts that are already locked in.

A new report explores which impacts are already locked in, identifies how Representative Concentration Pathway (RCP) scenarios fit into the conversation, and describes an approach to setting up scenario analysis for near-term physical climate risks.

As the effects of climate change increasingly threaten financial stability, investors and regulators are seeking to understand what impacts lie ahead, and calling for an increase in physical climate risk assessment and disclosure in line with the Task Force on Climate-related Financial Disclosures (TCFD). To assess the scale of financial risk posed by physical climate change, it is important to quantify risks under different climate scenarios. How will changes in extreme weather patterns, longer droughts and rising seas differ under various scenarios?

Answering these questions through scenario analysis helps uncover the range of risks, allowing investors to identify assets and markets that are more likely to become stranded over time and to begin developing forward-looking resilience strategies. However, science-driven, decision-useful scenario analysis poses many challenges for businesses and financial stakeholders today, due to complex feedback loops, varying timescales, and multiple interacting factors that ultimately determine how global climate change manifests.

The new report, "Demystifying Climate Scenario Analysis for Financial Stakeholders" (PDF), explores which physical impacts are already locked in, identifies how RCP scenarios apply, and describes an approach to setting up scenario analysis for near-term physical climate risks.

Different approach

Scenario analysis is often approached from the perspective of transition risk, where policy developments and greenhouse gas (GHG) emission targets are the key drivers of risk pathways over the near-term, in the next 10 to 30 years. Physical risk, however, requires a different approach. Impacts over the coming decades are largely locked in, making the emissions scenarios less relevant. Unlike transition risk, GHG emission pathways play a minimal role in the behavior of the near-term climate and GHG emission pathways only begin to meaningfully influence global temperatures near mid-century. The uncertainty in physical climate risks in the near-term is driven by uncertainty in in physical processes, rather than in policy decisions.

For organizations looking to construct physical climate risk scenarios for risk management and strategy purposes, it is critical to understand the scientific phenomena driving our plausible climate futures. The new report outlines an approach called percentile-based analysis, which allows users to explore the range of potential outcomes based on climate model outputs within a single RCP. This offers a flexible, data-driven approach, suitable for portfolio-level screenings, reporting and in some cases, direct engagement with asset managers.

Key takeaways:

  • Quantifying climate risks under different scenarios is a key element in understanding how physical climate risks pose financial risks.
  • Scenario analysis is often approached from the perspective of transition risk, where policy developments and greenhouse gas emission targets are the key drivers of risk pathways in the next 10 to 30 years. However, physical climate impacts over the coming decades are largely locked in, so physical risk requires a different approach.
  • Even if we stopped emitting carbon dioxide tomorrow, many physical climate impacts, such as increasing temperatures, more severe droughts and rising sea levels, already would be locked in because of the time carbon dioxide stays in the atmosphere and the time it takes the atmosphere to respond.
  • The uncertainty in how physical climate risks may manifest in the next few decades is driven by model uncertainty, which therefore should be the focus of scenario analysis for physical climate risks in the near-term.
  • Percentile-based analysis offers a flexible, data-driven approach, suitable for portfolio-level screenings, reporting and in some cases, direct engagement with asset managers.
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