- More central banks and regulators are releasing reports – and new requirements are emerging – on climate scenario analysis and stress tests amid continuing pushback.
- There remains disagreement over appropriate data and metrics to use for scenario analysis…
- … but some organisations are working on solutions, and there is growing consensus that climate scenarios need to incorporate more qualitative analysis – or ‘narrative’.
Regulators have been ramping up work on climate scenarios and stress testing, and pushing financial firms and other companies to do the same amid an international drive to improve climate risk assessment and disclosure. There is resistance from some parts of the market, but certain investors and practitioners are looking to help develop the data and metrics available, including putting a stronger focus on qualitative scenario analysis.
Climate scenario analysis involves assessing how an organisation – or investment portfolio – will fare in a possible future state, such as after a 2°C temperature rise. It can draw on data from climate stress tests, which assess an institution’s resilience to extreme conditions, such as losses in extreme weather events.
Just last month the European Central Bank published the results of its climate risk stress test and the Colombian central bank issued a report on the impact of climate change. Other supervisory bodies to have released climate stress test or scenario analysis-related material this year include, in chronological order, Bank Negara Malaysia, the Bank of England, Australia Prudential Regulation Authority, Financial Services Agency of Japan, Banque de France and Bank of Canada.
Meanwhile, from this coming October, in a global first, large UK pension funds will have to conduct scenario analysis to measure how aligned their investments are with the Paris Agreement. This forms part of the Task Force on Climate-related Financial Disclosures (TCFD) requirements.
Scenario analysis reporting – one of the TCFD’s recommended areas of disclosure – is improving but remains patchy, with only 13% of 1,651 listed companies disclosing in 2020 up from 7% in 2019. The figures are higher for asset owners and managers, at 35% and 25% respectively.
It doesn’t help investors that, according to the EY Global Climate Risk Disclosure Barometer 2021, only 41% of corporates are conducting climate scenario analysis. This figure is “concerning”, said the research, published in June this year and covering 1,100 firms across 42 countries.
Meanwhile, there has been pushback against regulatory efforts on climate scenario analysis and stress testing from banks and other institutions.
Stuart Kirk, HSBC Global Asset Management’s then head of responsible investment, criticised bank stress tests in May. He argued that central banks, such as those in the UK and Netherlands, had inserted extreme numbers into climate stress tests to achieve more alarming results, something refuted by the BoE’s climate chief.
The climate models and tests being employed are not perfect by any means, as Sarah Breeden, executive director for financial stability strategy and risk at the Bank of England has admitted.
A lack of sufficient data and metrics is a commonly cited concern, particularly when it comes to executing and reporting on forward-looking analysis. In fact many financial institutions have undertaken climate scenario analysis but not published their results because they don’t like the negative findings, Maarten Vleeschhouwer of 2 Degrees Investing Initiative, a scenario analysis provider, told Capital Monitor in October last year.
Nonetheless, there are institutions trying to do the best they can with the data and metrics they have, and moves are being made to improve the situation.
Push for more qualitative analysis
One area increasingly being seen as key is improving qualitative analysis – that is, putting more narrative context around climate-related metrics. Some work in this area is being kick-started by the Real World Climate Scenarios (RWCS) initiative, a group of climate risk professionals hosting a series of roundtables on the topic. The first took place on 4 May, incorporating a range of practitioners and policy experts named in the summary of findings.
RWCS is convened by Mark Cliffe, senior adviser at KPMG; Willemijn Slingenberg-Verdegaal, co-head of climate and ESG solutions at investment systems vendor Ortec Finance; and Mike Clark, founding director at responsible investment consultancy Ario Advisory.
Speaking to Capital Monitor, Clark says climate scenarios need improvements, such as more narrative context – that is, more qualitative information to accompany the quantitative data. “Narratives eat modelling for breakfast,” he adds.
Publicly available scenarios, such as those from Network on Greening the Financial System (NGFS), have models that are not fit for purpose, he adds. Shorter time frames – potentially five years or less – are needed to align with organisations’ decision-making horizons, and hard-to-model uncertainty – such as wars or pandemics – needs much greater recognition, says Clark. In addition, climate scenarios are often not suitable for providing outcomes for developing countries.
Ultimately, scenarios from NGFS and others fail to capture real-world factors, such as unemployment, politics and policy, concluded attendees of the RWCS roundtable hosted by Clark in May. There was consensus that narratives would help create explicit assumptions about non-modellable drivers such as politics.
The attendees also mapped out what they saw as key qualities of narrative scenarios and proposed a scenario construction process, as outlined in the summary document. In fact, one large asset manager is tendering for a narrative scenario provider, Capital Monitor understands.
The work of initiatives such as the Economics of Energy Innovation and System Transition, led by the University of Exeter in the UK, support RWCS’s approach.
And regulators appear to be taking note. Clark says he and other RWCS convenors have had discussions in recent months about the round table findings with central banks and regulators such as the Bank of England and Prudential Regulation Authority in the UK and New Zealand’s External Reporting Board.
And, in June, the UK Financial Conduct Authority’s Climate Financial Risk Forum, which already offers guidance on scenario analysis, announced it was developing an online climate scenario analysis narrative tool.
Narratives are an important but challenging part of climate scenario analysis, agrees Stephanie Maier, global head of sustainable and impact investment at Gam Investments. The Swiss fund house is one of the relatively few financial firms that discloses on climate scenarios for its investments – it does so for both equities and fixed income. Others include UK asset manager abrdn and German insurance group Allianz.
One challenge with these disclosures is helping the reader contextualise them, she tells Capital Monitor.
Climate scenarios: disagreements over data
Before they get to the qualitative disclosure, however, most financial firms are trying to settle on what quantitative data to use.
Gam itself uses four scenario analysis tools: MSCI’s Climate Value-at-Risk, to provide a forward-looking and return-based valuation assessment; the NGFS 1.5 orderly and disorderly transition scenarios, both of which are consistent with limiting global warming to below 2°C; the IPCC Representative Concentration Pathway 8.5 scenario, which assumes a 4°C rise by 2100 in a business-as-usual economy; and a representative benchmark to help contextualise the results (see charts below).
Both Gam and Norwegian pension fund KLP agree that single metrics, such as carbon footprint or carbon value-at-risk, are not sufficient, and tend to be backward-looking when scenario analysis should ideally be forward-looking.
No single metric would give the whole picture for a diversified investment portfolio such as KLP’s, said Heidi Finskas, the $80bn fund’s vice president of corporate responsibility, in late June at the Climate Investment Summit at the London Stock Exchange.
Weighted average carbon intensity (WACI) is one of the most popular metrics, she added, but it has come under criticism. KLP has a “huge bulk of investments” for which it uses general indicators such as WACI, she added.
It is a “fairly good” indicator of exposure to carbon emissions, she said, because it calculates emissions in proportion to revenues, but it is very sensitive to market developments and does not reflect absolute emissions. And, as a revenue-based metric, it punishes companies that are either small or in the development phase because they likely have a large amount of capital in investments, but low revenues.
WACI is also used by the likes of Gam and BlackRock, and recommended by the TCFD. But Finkas said each investor was likely calculating it in a different way as there was no single standard or definition on how to calculate it.
What is needed to really understand and track progress against climate targets, Maier argues, is a dashboard of metrics, such as exposure to carbon-related assets and financial impact of climate transition.
The increasing number of alternative data sources, such as satellite imaging to monitor greenhouse gas emissions, and more detailed mapping of physical risks should also help, she adds.
Ultimately, the sooner businesses are able to assess accurately the financial risks posed to them by climate change, the better they can prepare.
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