Scenario analysis: each journey starts with a few practical steps

Scenario analysis presents one of the biggest challenges organizations are facing when reporting climate information following the TCFD recommendations. Here are a few tips to get you started.

Climate change-related scenario analysis can be considered, in many respects, a very new exercise for many organizations. It involves marrying disciplines across the business and extending existing enterprise risk management systems to potentially include new categories of risk over longer time horizons. 

In response to this challenge, CDSB organized a webinar as part of its ongoing capacity building for signatories to our TCFD implementation commitment. The webinar was presented by ERM, a global sustainability consultancy and authors of the TCFD recommendations technical supplement on scenario analysis. If you missed the webinar, you can access it here.

Tips to get you started

1. Get internal engagement and buy-in

An important first step is to engage with all departments concerned with disclosure, including your finance and risk team, as well as sustainability. The application of their unique skills and resources to the challenge of financial modelling and enterprise risk management processes will be invaluable to conduct scenario analysis successfully and understand the materiality of risks and opportunities. 

This is particularly important when considering the results of scenario analysis in informing strategy responses and decision-making. Without engagement and coordination between departments, and without board level buy-in, the company’s work risks being relegated to a note in a report, rather than a key tool to assist it in building a resilient and prosperous business model.

2. Explore extremes and challenge conventional thinking in scenarios 

The TCFD recommendations specify that organizations should consider a 2ºC transition scenario. However, it is necessary to consider a number of plausible future paths to stress test the organization at the extremes of the “wedge” of future risk and opportunity   and use scenario analysis to test an organizations’ resilience and strategy responses to these.

Broadly, this means considering both physical as well as transition risks (and opportunities) where only one category may have been considered previously. Common examples could include a business as usual scenario, where the efforts to curb greenhouse gas emissions are limited, to consider the effects of extreme physical climate risks on your business, as well as the most ambitious pathways, under a 1.5 degree scenario, or exploring the timing and magnitude of the required transition.

3. Understand where your organization is on the learning curve

Organizations that are just starting to work on scenario analysis will need to consider a high-level scenario approach, taking into account the complete organizational profile, broad physical and transitional scenarios, and encompass second and third order risks from changes in other sectors and their supply chain, to establish the key areas of exposure.

More advanced reporters may consider a deeper dive into a particular area of risk as a first stage in scenario analysis, incorporating scenarios into financial models and quantifying material financial risk. 

In both respects though, this initial planning stage will be important to establish the necessary skills and resources required and establish guidelines and consistent, repeatable processes going forward.

4. Select the most suitable approach

Scenario analysis can be broadly defined in a top-down vs. bottom-up and a holistic vs. event-based approaches. Companies will benefit from understanding each and selecting the most appropriate for their current needs.

The top-down approach screens portfolios, business units or assets for climate impacts and is often used when climate impacts are broadly similar across these. This approach is suited to an initial high-level scoping.

The bottom-up approach looks at the granular business unit and asset level of already identified material climate risk exposure and opportunity. It may be too lengthy for an initial scoping but it needs to be considered particularly for risks and opportunities that vary across units, such as the physical risks of climate change by location.

The holistic approach looks at scenarios exploring global or market macro-trends shaped by general policy and is suited to be used in combination with the top-down approach for high-level scoping.

The events-based approach, selecting specific policies for certain technologies to be explored in greater detail in scenarios, marries well with the bottom-up asset level approach for deeper dives.

5. Take advantage of the resources available 

There are a vast range of resources and tools available to assist organizations when conducting scenario analysis, many of which are referenced in the TCFD technical supplement. There are resources covering global, sector and country-specific scenarios and tools to evaluate impacts and it is encouraged to use these resources so that organizations can be compared to some extent through their common use.

However, each organization will have its own risk and opportunity context, shaped by the markets and geographies they operate in, as well as the nature and lifespan of their assets. It is important therefore that organizations ultimately form their own scenarios and analysis practices that fit to the individual nature of their operations and aspirations.

An invaluable resource for organizations will be the recently launched TCFD Knowledge Hub that currently has over 100 resources available for scenario analysis alone. This will be regularly updated with the latest scenarios, guidance and case studies, and  organizations are encouraged to share their experience though the platform.  

6. Make scenarios fit for purpose

It is useful to always keep in mind the goal of the TCFD recommendations of evaluating material financial impacts when conducting scenario analysis. This can help inform and create a logic in the scenario analysis approach and make it useful for forming strategic responses.

Organizations can examine what the main driving factors of changes in revenues and costs are, for individual products and organizational units in varying sectors and geographies. Understanding these allows the creation of scenarios - to identify and test climate impacts - and define a range of strategic responses. In turn, this allows organizations to  answer specific questions, such as what will be the market opportunity created in a certain country under a range of policy options.

7. Work towards disclosure

A common mistake with scenario analysis is trying to define what constitutes “good” or “correct”.  As a result, many organizations are hesitant to disclose results from scenario analysis. 

It is important to understand that this is still an emerging discipline that will evolve and be a journey of learning particularly in sectors where this has not previously been widely undertaken.

Better practices will emerge, but it is important that organizations do not wait, but rather start acquiring knowledge, capacity and skills and build the scenarios relevant for their organization.

Before reporting on the outcomes of scenario analysis, organizations will need their processes to be robust and form their strategic responses to the highlighted risks and opportunities. Under our Beyond Disclosure programme, we are helping companies improve their reporting in line with TCFD recommendations.

If you would like to share your experiences of scenario analysis, tips, pitfalls and insights or would like to know more about the commitment or CDSB’s Beyond Disclosure, please get in touch.