TCFD signatories are expected to have climate change scenario analysis capabilities to “enhance critical strategic thinking”, and now the Bank of England requires UK banks and insurers to develop this capability too. And through the Network for Greening the Financial System, 40 further banking and insurance regulators have also said that they will implement equivalent requirements in their jurisdictions. One of the early and foundational decisions for firms to make on climate change is the approach to scenario analysis, either choosing a ‘tick-box’ mind-set and set of tools to do the minimum for compliance; or to set a clear business value strategy with dynamic scenario analysis. We passionately believe the latter is the ‘right’ choice, providing transparency to help board members and businesses make informed decisions today through a better understanding of climate change impacts on tomorrow’s world. It remains a choice and one any board will need to explain to its regulators, shareholders, employees and potentially its wider community.
Robust, dynamic climate change scenario analysis is difficult for most firms. Firstly, firms need to be able to capture the complex interconnectivity between different sectors. For example, the impact of electric vehicle uptake can have knock-on effects on electricity demand, and hence the generation sector, creating changes in further up the value chain on oil demand and pricing, as well as different pressures on abatement elsewhere in the system. Capturing these interconnectivities is important but complex.
Transparent flexibility is key
To enable that critical strategic thinking that TCFD, regulators and investors demand, the modelling framework needs to be transparent and flexible, enabling firms to see each of the individual parameters that overall define a set of assumptions, and to change these in an auditable way. This functionality is key for enabling ‘what if?’ analysis, and for involving and engaging the business in a clear thought process that builds real understanding. In other words, the modelling needs to be the polar opposite of ‘black box.’
The importance of zooming in and out
Firms also need the ability to ‘zoom’ in and out. Given the nature of both transition and physical risk, it is important that firms’ scenarios can be described in broad, global terms that can be related back to benchmarks such as the International Energy Agency scenarios. But to take full strategic advantage of scenario analysis, firms also need to be able to zoom in to understand local characteristics of their own portfolios and strategic interests.
These dynamic scenario analysis capabilities cannot be provided by most off-the-shelf scenarios or models, with no ability to adjust or flex according to each business, region, mandate, subsidy, tax jurisdiction. Choosing a dynamic scenario analysis approach means a business can engage in truly meaningful debate, relevant to its own strategic goals and risk appetite, whilst looking both near-term and over the horizon to the future.
Baringa can help
At Baringa we are advising numerous financial services, energy and public sector clients on climate change using our Prospect energy transition model. We have also recently announced a collaboration with XDI, the industry-leading provider of physical risk analytics, to enable us to provide comprehensive climate risk scenario analysis to our clients.
Contact us to learn more.