TCFD scenario analysis is considered an important and useful tool that enables an organization to understand how combinations of climate-related risks may affect its businesses, strategies and financial performance over time.
What is a Scenario Analysis?
Scenario analysis is a necessary part of building a climate strategy, assessing climate risks, and a key component of the recommendations for the Task Force for Climate-related Financial Disclosures (TCFD). As climate change progresses in the coming years and decades, uncertainty around how it will impact business requires the use of scenario analysis; the development of plans and strategies, relating to the range of possible future circumstances.
The extent and timeline of how climate change will develop are unknown, so making plans for every eventuality will mitigate an organization’s exposure to climate-related risks and create new opportunities. The TCFD recommends that scenario analysis be used to explore possibilities of how the world may look, create strategies against them, and report findings annually in climate reports. Building scenarios of plausible futures enables organizations to assess all possible physical and transitional risks involved in a changing climate and determine how they will affect their business and finances.
Scenario analysis can be quantitative, qualitative, or a mixture of both. Qualitative scenario analysis looks at trends, such as political developments, which can’t be quantified numerically. Whereas quantitative scenario analysis looks at numerical data and models, such as the possible weather patterns and sea level rises in a world of 2⁰C warming. Creating impactful scenarios relies on being consistent and logical and being grounded in making reasonable assumptions of how the future may look as climate change progresses.
As global climate disclosure mandates such as the SEC’s continue to converge around the guidance of the TCFD, the framework has quickly become the global gold standard for climate disclosures. The importance of understanding the how, why, and when to conduct a scenario analysis will become increasingly pertinent to organizations around the world.
>> Want to learn more about TCFD? Download our eBook: The TCFD's Role in Emerging Climate Disclosures
Why Should Organizations Conduct a Scenario Analysis?
In an increasingly uncertain world, where climate risks are financial risks, organizations need scenario analysis to understand the physical effects of a changing climate on its operations, for example, in the form of rising sea levels and unpredictable weather patterns, as well as the effects of the global transition to a low carbon economy.
Conducting a series of comprehensive and robust scenario analyses allows companies to improve their decision-making and gives decision-makers more information to build strategies and adapt to the many possible outcomes. Scenario analysis helps companies track and monitor the progression of different scenarios and make adjustments based on temperature rises, emissions trends, and more. Additionally, reporting on scenario analysis in annual ESG reports gives investors and stakeholders an understanding of how robust an organization's assessment of its climate risks and opportunities is, which they can compare to other organizations and use to make investment decisions.
What Climate-Related Risks and Opportunities Should be Considered in a Scenario Analysis
Organizations just starting out can begin by using solely qualitative methods of scenario analysis, creating narratives for what the future may hold. And as they gain experience, they can develop quantitative scenario analysis with numerical data and models. A good place to start is with models that have already been created by the IPCC and EIA.
To develop a scenario analysis specific to the organization, companies must assess their climate risks and opportunities. Climate risk and opportunities typically fall into two categories: transition and physical. Physical risks include changes in weather patterns and more frequent and severe weather events - these can impact businesses through interruptions or damage to business operations and supply chains. Transition risks include market and technology shifts on the way to a low carbon economy, reputational risks from growing stakeholder pressure to act and report on climate change, and regulatory and legal risks from an evolving landscape of carbon disclosure and tax requirements.
How to Conduct a Scenario Analysis
Scenario analysis is very specific to each organization and will vary depending on the sector, industry, geographies of operations and supply chain, organization structure, and key stakeholders. All of these must be considered when assessing business impacts on climate risks and opportunities.
To develop a robust scenario analysis specific to the risks and opportunities of an organization, take this six-step approach:
- Ensure governance - Integrate scenario analysis into the strategic development of the organization and ensure the correct internal and external stakeholders are involved.
- Assess materiality of climate risks - Conduct an assessment to determine what factors are likely to be significant to the operation and finances of your organization:
- What technological and market shifts are likely to happen in a transition to a low-carbon economy?
- How will exposure to climate risks affect your organization's reputation?
- What physical risks, such as flooding, is your organization likely to be exposed to?
- What policy and legal developments are likely to be relevant to your organization?
- Identify and define a range of scenarios - Recognize all plausible climate outcomes, including transition risks such as a carbon tax and physical risks such as the availability of water in water-stressed areas.
- Evaluate business impacts - Assess scenarios' impact on operational costs, regulatory compliance costs, supply chains, and business interruption.
- Identify potential responses - Responses to these scenarios may include investments in new technologies, changes to business models and processes, and a mix of portfolio investments.
- Document and disclose - Document the scenario analysis process and disclose it in your annual sustainability reports.
What Tools to Use
There is currently a range of tools available to help companies conduct climate scenario analysis. Some are more general tools, like Climate Information Portal (CLIPC). CLIPC takes a host of data from field observations, satellite imagery, climate models, and more to get a complete view of the possible climate impacts organizations may have. Whereas others are more sector-specific or climate change impact-specific tools, such as the United Nations Food and Agriculture Modeling System for Agricultural Impacts of Climate Change, or the World Resource Institutes Aqueduct tool, which tracks water risks emerging around the world.
As global climate disclosure policies continue to converge around the TCFD, scenario analysis will be increasingly important to understand and conduct. To get a better understanding of the TCFD’s role in shaping climate policies, Persefoni conducted an analysis comparing three major proposed climate policies and their alignment and additions with the TCFD framework. You can download our free “The TCFD’s Role In Emerging Climate Regulations” analysis today.