What climate-related risks is your organization prepared for?

By

Mathew Nelson

EY Global Climate Change and Sustainability Services Leader

Leading a purpose-driven team that shares a common passion for creating positive impact. Workplace diversity and equality advocate. Engineer. Father of two boys. Australian Football League fan.

9 minute read 9 Aug 2019

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As climate-related risks and opportunities grow in prominence, organizations should consider undertaking climate-related scenario analysis.

According to the recent EY investor survey, Does your nonfinancial reporting tell your value creation story?, 47% of investors would reconsider investment based on climate risks.1

To respond, businesses should be better informed of potential climate-related financial risks, and how they can best be managed and communicated.

This is a message reflected in the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, which urge organizations to take account of climate-related issues and disclose the financial impact that climate-related risks have, or could have, on their business.  

However, while the topic of climate-related risks is becoming more prominent, many organizations do not have a clear understanding of the range and magnitude of potential financial impacts resulting from climate change in the short and long term. This is because climate-related risks are inherently more complex and long term in nature than most traditional business risks, contributing to a lack of clear understanding and measurement capabilities to assess the potential impacts on an organization’s operations and performance.

To solicit decision-useful, forward-looking information on the financial impact of climate-related risks and opportunities, organizations should be conducting climate-related scenario analysis.

This article examines the steps required for scenario analysis and modeling, and how to manage exposure to climate risks. 

So what is scenario analysis and how can it be applied to climate-related risks?

The scenario analysis approach – in the context of climate change – allows organizations to explore some of the impacts of different climate futures on sectors of the economy, the scale of change and (model dependent) the timing of change. Climate scenarios do not predict the future. Their purpose is to offer alternative views of future climate trajectories that:

  • Deal with outcomes that are highly uncertain, medium to long term, with the potential for complex and substantial disruptive effects
  • Enhance organizations’ strategic conversations about the future by considering scenarios where climate-related impacts can be significant
  • Assist organizations to frame and assess the potential range of plausible business, strategic and financial impacts from climate change and government policies and regulations
  • Assist investors in understanding the robustness of organizations’ strategies and financial plans, and in comparing risks and opportunities

The applications for scenario analysis are broad. They can be used to:

  • Evaluate the potential resiliency of the strategic plans of a business to the range of scenarios
  • Assist in identifying options for responding to the organization’s strategic and operational risks
  • Provide insights to possible opportunities that could be identified through adjustment to strategic and financial plans
  • Support disclosures required to respond to stakeholder demands

Knowing where to start in building scenarios can be daunting. However, there are some external guidance and frameworks that can help organizations apply scenario analysis to climate-related risks, including:

  • TCFD’s Technical Supplement, The Use of Scenario Analysis in Disclosure of Climate-Related Risk and Opportunities2
  • Publicly available climate-related scenarios from the Intergovernmental Panel on Climate Change (IPCC) and International Energy Agency (IEA), whiclh can be tailored by organizations to fit their own particular circumstances

Understanding the risks and opportunities from climate change

Before performing scenario analysis, organizations should understand their climate change transition, and physical impact risks and opportunities as per the TCFD recommendations.3

 

Definition

Climate-related opportunity                                                                                                    
Efforts to mitigate and adapt to climate change will likely result in new opportunities, such as through resource efficiency and cost savings, the adoption and utilization of low-emission energy sources, the development of new products and services, and building resilience along the supply chain. Climate-related opportunities will vary depending on the region, market and industry in which an organization operates.
Climate-related risk                                                                          Physical risks emanating from climate change can be event-driven (acute), such as increased severity of extreme weather events (e.g., cyclones, droughts, floods and fires). They can also relate to longer-term shifts (chronic) in precipitation and temperature, and increased variability in weather patterns (e.g., sea level rise). Climate-related risks can also be associated with the transition to a lower-carbon global economy, the most common of which relates to policy and legal actions, technology changes, market responses and reputational considerations.

Using these definitions to identify potential climate-related risks and opportunities, organizations can start planning for their scenario analysis. They also help explore alternatives that may significantly alter the basis for “business-as-usual” assumptions and identify opportunities through innovation.

Key considerations

There is no “one solution fits all,” and organizations will have to look at their own circumstances and value chain when undertaking this analysis. Not only are the Intergovernmental Panel on Climate Change (IPCC) and International Energy Agency (IEA) providing different possible scenarios when it comes to global warming (i.e., changes of 1.5 oC, 2 oC, 3 oC or 4oC), the actual impacts of these possible scenarios may be very different in different parts of the world, and on different time scales. In different regions, climate change could be felt as more extreme temperatures, rise in sea levels or more hurricanes, rather than as a slow and steady increase in the temperature across months.

While scenario-analysis is not new, applying it to climate change is relatively recent, and there is much to be learned and understood. In addition, as more organizations start applying climate risk-related analyses, particularly in response to the TCFD recommendations, an increasing number of challenges are arising, such as:

  • Which scenarios an organization should explore
  • How climate change should be addressed from a business strategy perspective
  • The physical, economic and regulatory connection between climate change and business and supply chain activities
  • Consistent methods and assumptions used to support the scenario analysis
  • Rigor and sophistication in the use of data set inputs

Over time, and as data needed to create more refined scenario analysis becomes available, organizations should be able to improve the key inputs, outputs, assumptions and analytical methods. But this shouldn’t stop organizations from starting now to understand the risks and opportunities associated with climate change, and applying scenario analysis and modeling.

Organizations should remember that this is a journey and not all analyses and risk assessments need to have a concrete quantitative outcome; they can be qualitative as a start.

What are organizations doing?

While many organizations are reporting on climate-related risk disclosures, only a few seem to be currently deploying a forward-looking scenario analysis to support their strategic vision of how to protect and to create value.

According to the EY Climate Risk Disclosure Barometer 2018, How are your climate change disclosures revealing the true risks and opportunities of your business? 4 (which provides a snapshot on the update of TCFD recommendations based on an assessment of over 500 companies), around 12% of companies assessed are disclosing information on scenario planning. But this was mostly in the context that the companies expected to conduct the analysis in the future. In most cases, no detail was given around the scenarios analyzed or the results of the modeling. Several organizations also disclosed their support for a 2°C future, but did not state how their business aligned with such an economy. Where organizations had undertaken detailed scenario analysis, generally, the scenarios only dealt with transition risks and not physical risks.

This aligns with findings from the TCFD’s research into the status of disclosure practices where two of the five key takeaways related to the use and disclosure of climate-related scenario analysis. Specifically, the findings included “information on strategy resilience under climate-related scenarios is limited” and “financial implications are often not disclosed.”5

Where to start?

Organizations that seek to understand their climate-related risk exposure should ask themselves the following questions and get familiar with the following concepts and misconceptions of scenario analysis:

        Questions to ask

  Concepts to understand                       

        Misconceptions

  • Are some of my products or activities at risk regarding the 2°C road map? How can I turn this into a competitive advantage?
  • What are the biggest emission sources in my value chain?
  • What type of climate-related risks could my business be exposed to in the long-run (i.e., sectors, geography, assets, structure and dynamics of the organization’s supply and demand markets that may impact the business)?
  • Are international climate policies and national commitments integrated into my business strategy, supply chain or sourcing strategy?
  • An organization may want to familiarize itself with relevant scenarios developed by the IEA and the IPCC, given they are the most recognized by scientists and policy-makers to assess future vulnerability to climate change.
  • An organization may wish to consider the options and categories related to scenario analysis: parameters used (e.g., discount rate, gross domestic product, other macroeconomic variables and demographic variables).
  • An organization should consider available assumptions (e.g., related to policy changes, technology development and deployment, energy mix, price of key commodities or inputs, geographical tailoring of transitional and physical impacts, and timing of potential impacts).
  • The scenario analysis has to be perfect and finalized; organizations are embarking on a multi-year journey. Indeed, data does not have to be perfect as long as assumptions and uncertainties are disclosed and understood.
  • Organizations do not have to start from scratch; there are a number of scenarios available for organizations to leverage as a starting point.

It may take several years for an organization to be in a position to generate valuable information for investors and shareholders to help them make informed decisions. However, the earlier that organizations embark on this journey and start performing scenario analysis, the better positioned they will be to engage with investors and shareholders on the impacts and opportunities related to climate change. 

EY Climate Change and Sustainability Services (CCaSS) teams can support organizations as they develop and implement their climate-related risk strategies, including their scenario analysis. 

Certain services and tools may be restricted for EY audit clients and their affiliates to comply with applicable independence standards. Please ask your EY contact for further information.

Summary

While the topic of climate-related risks is becoming more prominent, many organizations do not have a clear understanding of the range and magnitude of the potential financial impacts resulting from climate change. Conducting climate-related scenario analysis can help organizations understand the financial impact of climate-related risks and opportunities.

About this article

By

Mathew Nelson

EY Global Climate Change and Sustainability Services Leader

Leading a purpose-driven team that shares a common passion for creating positive impact. Workplace diversity and equality advocate. Engineer. Father of two boys. Australian Football League fan.