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Why do we need climate change scenario analysis? One of the consequences of the COVID-19 pandemic is the growing realization companies that ignore potentially catastrophic external risks are unlikely to have the resilience to deliver financial returns over the long term. One of such potential external risks is climate change, which impact financial returns with varying degrees across sectors and geographies. The risks are real and present, and not just in the future.
As the impact of climate change becomes more and more apparent, many companies are overhauling their governance structure and risk frameworks while adopting a key recommendation made by the Task Force on Climate-related Financial Disclosures (TCFD), which is to conduct scenario analysis in order to understand how different possible climate futures will affect their businesses.
What is TCFD climate change scenario analysis?
Scenario analysis is a technique used to enhance critical strategic thinking. It refers to the process of analyzing and quantifying various possible events that could take place in the future and predicting various feasible results.
Scenario analysis doesn’t attempt to predict a single possible outcome but rather evaluates a spectrum of different potential situations and outcomes ranging from a best-case to a worst-case scenario. It is a tool that has been used for over a half-century by corporations worldwide to hold conversations about different potential impacts of uncertain futures.
TCFD scenario analysis allows organizations to explore and develop an understanding of how a combination of climate-related risks may affect their businesses.
Undertaking scenario analysis enables companies to frame climate risks and opportunities in the context of potential future warming scenarios so they can assess the various impacts arising from climate change across their value chain, make the necessary preparations and demonstrate their resilience to their stakeholders.
Why businesses need TCFD climate scenario analysis?
Generally, most changes that drastically impact organizations happen unexpectedly and suddenly, with the global pandemic in 2020 being an excellent example. These changes bring to the fore the need to conduct scenario analysis to analyze and quantify potential business impacts of such events so they can plan effectively.
In a similar vein, organizations today are starting to realize the importance of assessing and managing needs (risks) and benefits (opportunities) from identifying climate change risks that their organizations may be exposed to both now and in future.
The severe effects of climate change threaten the global economy as well as local communities. A climate scenario analysis is vital in that it helps to clearly define the risks (and opportunities) so mitigation efforts can be developed and applied.
According to the TCFD, climate risks can be broadly categorized into two namely transition risks and physical risks.
1. Climate transition risks
This refers to risks created by the world’s transition to a low-carbon economy as a result of carbon policy changes. Transition risks include:
- Policy and legal risk, market risk: Companies subject to regulatory developments related to climate change and energy-specific regulations globally. Examples include regulation of greenhouse gas (GHG) emissions, carbon pricing, fuel mix, energy, and fuel cost and energy policy. Additionally, there are changes in the market, which includes the demand and supply of certain commodities, products and services.
- Reputational risk: As the subject of climate change continues to garner more attention, there is the reputational risk in that businesses that are seen as not doing enough or not actively contributing to climate change mitigation may fall out of favor.
2. Climate physical risks
Physical risks here imply the risks that emerge due to a changing climate, particularly in the absence of carbon policy measures. These include:
- Acute physical risks: Examples of acute physical risks include tropical cyclones (hurricanes and typhoons), flooding, wildfire, drought and heat wave. The common denominator here is harsh weather conditions that may result in disruption of operations. This could either be due to facilities becoming inaccessible or rising costs of repairing them after damage.
- Chronic physical risks: Unlike the former, physical risks under this sub-division comprise climate and weather patterns including levels of precipitation, mean temperatures and sea-level rise. The consequence is that operational costs may skyrocket due to changes in climate patterns via increased energy usage and spend. In turn, this may also lead to low productivity.
In a nutshell, the goal of TCFD climate scenario analysis is not to impose specific methodologies on how to address climate risk but to explore alternatives that may significantly alter the basis for “business-as-usual” assumptions. The key benefits of TCFD scenario analysis can summarized as follows:
- It helps organizations manage risks more proactively by assessing the impact of potential climate change issues.
- It supports strategic planning and assists businesses in making better decisions by investigating the risks and benefits of multiple climate scenarios.
- It raises awareness throughout departments and drives culture change that is both risk and climate focused.
- The well-established and proven method of evaluating the future enables companies to spot opportunities or risks that may otherwise be overlooked.
Because of the reasons for TCFD climate change scenario analysis above, companies today are leveraging technology to categorize and plot the major risk ‘hotspots’ through operations and along the supply chain, identifying areas of attention. Using ESG Enterprise TCFD reporting software greatly improves the process of assessing the risks and opportunities from the shift of a low-carbon economy and the physical impacts of climate change.
TCFD scenario analysis might seem challenging but is a critical component of understanding and preparing for the impact of climate change. The ultimate goal of the process is to enhance strategic planning and identify gaps in risk management so organizations can take the necessary preparations and demonstrate their resilience to their stakeholders.