The essentials of climate scenario analysis for financial institutions

Climate change is already a reality. What has yet to be determined is how, and to what extent, the physical, transition and market risks associated with climate change will affect economies, financial institutions, and investment portfolios over the short- and long-term horizons. As our future climate becomes increasingly uncertain, it is vital that major financial institutions that collectively manage the world’s purse strings, proactively and effectively quantify the financial impacts of climate change so that they can be adequately prepared for its potential effects.

Climate Scenario Analysis (CSA) is now recognized as a critical tool to systematically examine plausible future climate-related outcomes[1]. While not a forecasting tool, a credible CSA which covers key economic and financial metrics, such as GDP, inflation and asset class risk and return, helps financial institutions understand how different climate-related outcomes could manifest and impact investment portfolios. By analyzing different climate scenarios, financial institutions can identify an array of risks and opportunities associated with specific climate futures, enabling them to make informed decisions and take appropriate actions.

Given the value of this approach for climate-related risk management, there is now a wide array of climate scenarios available in the market which draw on a range of models and inputs. Choosing a suitable approach for a CSA is not only essential to ensure insights are reliable and credible but also that they are tailored to the needs and the context of the business or investment in question.

There are five key elements that are critical to ensuring a CSA is suitable to generating financial insights to support strategic asset allocation decisions and for stress testing purposes.

1. Incorporate a comprehensive range of plausible climate pathways that reflect uncertainties in climate change, global regulations and policies, and the use of technologies to mitigate climate impacts.
2. Ensure thorough coverage of transition, physical, and market risks - that is the impact of transitioning to a low-carbon economy, the physical effects of climate change, and how financial institutions price in these risks and respond to market shocks.
3. Use a top-down approach, which is critical for understanding the overall effects and magnitude of climate-related risks, whilst still allowing for granular modeling at country, sector, and asset-class levels, to provide actionable financial insights.
4. Draw on simulation models that realistically reflect the speed of change and account for limiting factors and constraints under hypothetical climate scenarios.
5. Finally, ensure any views or assumptions are plausible and realistic so that the results are valid and informative, with the option to test projected impacts through sensitivity analysis.

These five elements are critical for drawing useful insights from a CSA. While it is important to stress that there are limitations and caveats associated with any model results, the insights gained can still be of considerable value for making informed investment decisions and adapting to an uncertain future.

[1] Financial Stability Board (2022), Climate Scenario Analysis by Jurisdictions: Initial findings and lessons

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