Climate change poses a systemic risk to institutional investors. All portfolios are exposed to it, yet the impacts will be uneven across asset classes, sectors and geographies. Understanding how this could play out is of central importance to investors’ response to the climate challenge. A key approach is the use of scenario analysis to test the resilience of the portfolio to a number of future states. This can further be developed for financial analysis.
This paper primarily seeks to help investors, both Asset Owners and Asset Managers and their service providers to:
understand an end point ambition requires a scenario pathway to be of use in financial analysis;
understand the scenario pathway architecture (defined in this paper as key variables, metrics, attributes and drivers) determine the financial impact of any scenario. This can be used to compare and contrast scenarios;
understand how climate scenarios can then be used in risk analysis of their own portfolios and engagement with companies following the Paris Agreement and the IPCC SR1.5°C study;
understand how scenarios can then become base case forecasts to begin to inform actual business and portfolio planning and decisions using business level metrics such as production, capex and emissions, which leads to action.
Investors can use scenarios to inform engagement with companies and/or directly to inform their portfolio construction.
Whatever investors adopt will be of great interest to companies and should certainly be a key input to their own thinking and approach.
This is also of relevance in a TCFD disclosure/reporting context for investors, as well as the EU sustainable finance taxonomy, which takes a bottom up economic activity approach and has set thresholds following a trajectory consistent with the EU -55% by 2030 and Net Zero by 2050.
The NGFS and other regulatory bodies, such as EIOPA, are also working on scenarios for full blown stress testing for financial institutions which may have implications for investors too. The classifications of “orderly vs disorderly” and “met vs unmet” will become well used, as will scenarios fitting into that.