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November 22, 2022updated 25 Nov 2022 12:00pm

Explainer: Climate scenario analysis into reporting

It’s official! Climate-related scenario analysis is to be a mandatory component of financial reporting. We detail what that means.

By Silvia Pellegrino

climate scenario analysis
High tide. A villager in Java, Indonesia lives with the threat of flooding on a daily basis. (Photo by Faisal Ramadhan/SOPA Images/LightRocket via Getty Images)
  • The International Sustainability Standard Board wants climate scenario analysis to be mandatory.
  • Climate scenario analysis is an approach used to understand how climate change will influence businesses.
  • According to Climate Scenarios, there are seven major climate scenarios to work from.

It’s official! Climate-related scenario analysis is to be a mandatory component of financial reporting after the International Sustainability Board (ISSB) announced all companies must produce accurate reports on their climate resilience as well as their routes to tackle risks.

In particular, the ISSB agreed to several specific policies. For instance, an entity now has to disclose its absolute gross GHG emissions generated during the reporting period, as well as disclosing the approach used and the reasons.

This is due to the fact that global warming and climate change will affect not only the physical components of the world but also its economy and finances. Even though the precise threats and implications of climate change are unclear, there are some ways for establishing a carbon-neutral economy. One option is to limit global warming to 1.5°C-2°C  above pre-industrial levels, although this is looking increasingly unlikely to happen.

The Task Force for Climate-Related Financial Disclosures (TCFD) has developed a framework to assist with scenario analysis preparation.

The ISSB also confirmed other steps to take in a scenario analysis. On 1 and 3 November 2022, the ISSB published the “Updates”, as a follow-up to the other update shared on 21 October. The three key decisions are:

  • Updating definitions of materiality,
  • Updating GHG and scenario analysis protocol,
  • Re-structuring TCFD architecture.

The latter confirms that the use of TCFD architecture is the basis of the ISSB standards. Companies must also follow the Sustainability Accounting Guidelines Board criteria when choosing which sustainability concerns to report on and making pertinent disclosures.

What is climate scenario analysis?

Climate scenario analysis is an approach used to understand how climate change will influence businesses and companies, since it allows for more in-depth thinking about future and eventual risks and possibilities, particularly in the case of climate change.

Before defining climate scenario analysis, it is helpful to first establish what a scenario is. According to the TCFD, “a scenario describes a path of development leading to a particular outcome.”

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This means that scenarios are purely hypothetical, but they aim to highlight all the risks and possible future developments. They are not, by any means, a totally accurate representation of tomorrow

A climate scenario analysis needs to have certain characteristics: it has to be plausible, distinctive, consistent, relevant and challenging. Each scenario should focus on a distinct set of critical factors, such as the geographic location of the company, its assets, supply and demand markets, customers and stakeholders, that interact in diverse ways and are linked by convincing logic.

What is the purpose of climate scenario analysis?

Because of climate change, companies have to be prepared for all climatic outcomes that may affect their ability to generate revenue. This is where climate scenario analysis comes into play, by allowing enterprises to compare their business models against the impacts of climate change. 

The most effective way to identify the main climate threats and the effectiveness of the climate plan is by having a materiality assessment, such as stress tests and research on structural changes. 

The Bank of England‘s 2021 preliminary assessment on climate risk serves as an example of scenario planning in action. To reach net-zero UK greenhouse gas emissions by 2050, three scenarios were included in the Climate Biennial Exploratory Scenario (CBES). Early Action (EA), Late Action (LA), and No Additional Action (NAA) are the three possible routes.

Following this first assessment, the Bank of England came to a number of conclusions. Governments’ public climate policies will have a substantial impact on the speed and type of the global economy’s development. It is in everyone’s best interest for banks and insurers to manage climate-related financial risks in a way that encourages long-term change. To do so, they will need to improve their handling of climate risk. Despite the fact that scenario analysis is still in its early phases, the CBES has already helped to enhance data. Finally, the Bank of England will continue to focus on scenario analysis to create a balance in climate risk management by supporting efforts to assist bridge data gaps.

This, ultimately, is the main objective to try to prevent further climate risks from happening by tackling them with the right actions. In order to find the right actions, it is vital for companies, businesses and even banks to assess all the possible scenarios

What are the different climate scenarios?

So far, scientists and policymakers have relied on a few preset scenarios, such as those developed by the International Energy Agency (IEA) and the Intergovernmental Panel on Climate Change (IPCC). 

In terms of future perspectives, these scenarios must consider predicted population levels, economic activity, political structure, societal norms, and patterns in order to act as meta-scenarios that cast more light on the trends of certain sectors or enterprises.

The two commonly recognised scenarios — one in which rapid decarbonisation leads to a 2°C outcome, and the other in which emissions stay high and physical climatic impacts reign supreme (baseline scenario, without a policy of intervention) — are frequently used as the context for continued improvements.

In climate scenario analysis, seven main types of scenarios might emerge, according to Climate Scenarios:

  • Socioeconomic scenarios depict the evolution of social standards and interpersonal behaviour with the climatic system.
  • Scenarios of emissions, concentrations, and climate forcing. Climate change scenarios caused by human intervention.
  • Climate damage scenarios are a consequence of climate change.
  • Mitigation options would minimise the effects of man-made climate change.
  • Scenarios of adaptation that reduce the effect of climate change on societies.
  • Integrated scenarios, which are a composite of the preceding situations.

These different scenarios are sub-categorised into projections, pathways or both. The main questions that companies should ask before developing climate scenarios are “What can happen?” and “What should happen?”.

More ISSB updates are planned in the coming months, and once finalised, the ISSB Standards will be formally constructed to serve as a comprehensive global baseline for sustainability- and climate-related reporting. The most significant component of the process is reporting critical data, so if organisations haven’t already started doing so in compliance with the Updates, now is the time.

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