Scenario analysis is a well-established method for developing strategic plans that are more flexible or robust to a range of plausible future states.
1. What is scenario analysis?
What is a scenario?
- A scenario describes a path of development leading to a particular outcome.
- Scenarios are not intended to represent a full description of the future, but rather to highlight central elements of a possible future and to draw attention to the key factors that will drive future developments.
- They are hypothetical constructs, not forecasts, predictions or sensitivity analyses.
What is scenario analysis?
- Scenario analysis is a tool to enhance critical strategic thinking.
- A key feature of scenarios is that they should challenge conventional wisdom about the future.
- In a world of uncertainty, scenarios are intended to explore alternatives that may significantly alter the basis for “business-as-usual” assumptions.
Scenario analysis characteristics
- The events in the scenario should be possible and the narrative credible (i.e. the descriptions of what happened, and why and how it happened, should be believable).
- Each scenario should focus on a different combination of the key factors.
- Scenarios should be clearly differentiated in structure and in message, not variations on a single theme.
- Multiple scenarios should be used to explore how different permutations and/or temporal developments of the same key factors can yield very different outcomes.
- Each scenario should have strong internal logic.
- The goal of scenario analysis is to explore the way that factors interact, and each action should have a reaction.
- Neither actors nor external factors should completely overturn the evidence of current trends and positions unless logical explanations for those changes are a central part of the scenario.
- Each scenario, and the set of scenarios taken as a whole, should contribute specific insights into the future that relate to strategic and/or financial implications of climate-related risks and opportunities.
- Scenarios should challenge conventional wisdom and simplistic assumptions about the future.
- When thinking about the major sources of uncertainty, scenarios should try to explore alternatives that will significantly alter the basis for business-as-usual assumptions.
2. Developing and applying scenario analysis
Organizations may choose to start with qualitative scenario narratives or storylines to help management explore the potential range of climate change implications.
The scenarios and associated analysis of development paths can use quantitative information to illustrate potential pathways and outcomes.
Greater rigor and sophistication in the use of data sets and quantitative models and analysis may be warranted.
Quantitative approaches may be achieved by using existing external scenarios and models (e.g., those provided by third-party providers) or by organizations developing their own, in-house modeling capabilities.
Organizations should include scenario analysis into strategic planning and/or enterprise risk management processes by:
- Identifying and defining a range of scenarios, including a 2°C scenario, that provide a reasonable diversity of potential future climate states.
- Evaluating the potential resiliency of their strategic plans to the range of scenarios.
- Using this assessment, identify options for increasing the organization’s strategic and business resiliency to plausible climate-related risks and opportunities through adjustments to strategic and financial plans.
Over time, organizations can improve disclosure through documenting:
- Management’s assessment of the resiliency of its strategic plans to climate change.
- The range of scenarios used to inform management’s assessment, including key inputs, assumptions, and analytical methods and outputs (including potential business impacts and management responses to them).
- The sensitivity of the results to key assumptions
a. Considerations for building climate change into scenario analysis
1. An organization may want to familiarize itself with relevant scenarios that are already developed.
- The scenarios developed by the International Energy Agency (IEA) and Intergovernmental Panel on Climate Change (IPCC) have long been used by scientists and policy analysts to assess future vulnerability to climate change.
- Producing these scenarios requires estimates of future population levels, economic activity, the structure of governance, social values, and patterns of technological change and hence can serve as “meta-scenarios” to provide an overall context and set of macro trends for the development of company or sector-specific scenarios. However, both have inherent sets of assumptions and biases on the future path of development, which does not span the full spectrum possible future pathways. This would need to be taken into account if a more disruptive scenario were to be developed.
- Appendix 1 provides a more in-depth discussion of the IEA and IPCC scenarios.
2. An organization needs to understand the nature of the climate-related risks and opportunities it may face.
- Each organization faces a different blend of climate-related risks and opportunities.
- The business impacts related to climate change may vary significantly depending on the industry and economic sector(s)/sub-sector(s) in which an organization operates.
- Business impacts may also vary significantly depending on the following:
- the geographic location of the organization’s value chain (both upstream and downstream).
- the organization’s assets and nature of operations.
- the structure and dynamics of the organization’s supply and demand markets.
- the organization’s customers.
- the organization’s other key stakeholders.
b. For investors, scenario analysis may be applied in different ways, depending on the nature of the asset(s) being considered
- Some investors may develop energy transition pathways that they believe to be either optimal and/or likely and use those pathways to measure individual potential investments and drive engagement activities
- Other investors may consider how climate-related scenarios relate to the future performance of particular sectors, regions, or asset classes
- The results may show that some portions of a portfolio are set to benefit from a particular scenario, while others face a loss in value
- Such results, while not conclusive, can be a useful additional factor in determining where to prioritize risk management activities and where to consider making additional allocations
c. Typical categories of climate-related risks and opportunities
Market and Technology Shifts
Policies and investments to deliver a low carbon emissions economy.
- Reduced market demand for higher- carbon products/commodities
- Increased demand for energy-efficient, lower-carbon products and services
- New technologies that disrupt markets
Growing expectations for responsible conduct from stakeholders, including investors, lenders, and consumers.
- Opportunity to enhance reputation and brand value
- Risk of loss of trust and confidence in management
Policy and Legal
An evolving patchwork of requirements at international, national, and state level.
- Increased input/operating costs for high carbon activities
- Threats to securing license to operate for high carbon activities
- Emerging concern about liabilities
Chronic changes and more frequent and severe extremes of climate.
- Increased business interruption and damage across operations and supply chains with consequences for input costs, revenues, asset values, and insurance claims
Sources: CDP, Climate Change Questionnaire, 2017. Task Force on Climate-related Financial Disclosures, Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures, June 2017.
d. Process for applying scenario analysis to climate-related risks and opportunities
1. Ensure governance is in place: Integrate scenario analysis into strategic planning and/or enterprise risk management processes. Assign oversight to relevant board committees/sub-committees. Identify which internal (and external) stakeholders to involve and how.
2. Assess materiality of climate-related risks
What are the current and anticipated organizational exposures to climate-related risks and opportunities? Do these have the potential to be material in the future? Are organizational stakeholders concerned?
3. Identify and define range of scenarios
What scenarios (and narratives) are appropriate, given the exposures? Consider input parameters, assumptions, and analytical choices. What reference scenario(s) should be used?
4. Evaluate business impacts
Evaluate the potential effects on the organization’s strategic and financial position under each of the defined scenarios. Identify key sensitivities.
5. Identify potential responses
Use the results to identify applicable, realistic decisions to manage the identified risks and opportunities. What adjustments to strategic/financial plans would be needed?
6. Document and disclose:
Document the process; communicate to relevant parties; be prepared to disclose key inputs, assumptions, analytical methods, outputs, and potential management responses.
3. Analytical choices involved in scenario analysis
Discount rate – what discount rate does the organization apply to discount future value?
Carbon price – what assumptions are made about how carbon price(s) would develop over time (within tax and/or emissions trading frameworks), geographic scope of implementation, whether the carbon price would apply only at the margin or as a base cost, whether it is applied to specific economic sectors or across the whole economy and in what regions? Is a common carbon price used (at multiple points in time?) or differentiated prices? Assumptions about scope and modality of a CO2 price via tax or trading scheme?
Energy demand and mix – what would be the resulting total energy demand and energy mix across different sources of primary energy e.g. coal/ oil/ gas/ nuclear/renewables (sub-categories)? How does this develop over time assuming supply/end-use efficiency improvements? What factors are used for energy conversion efficiencies of each source category and for end-use efficiency in each category over time?
Price of key commodities/products – what conclusions does the organization draw, based on the input parameters/ assumptions, about the development over time of market prices for key inputs, energy (e.g. coal, oil, gas, electricity)?
Macro-economic Variables – what GDP rate, employ-ment rate, and other economic variables are used?
Demographic variables – what assumptions are made about population growth and/or migration?
Efficiency – to what extent are positive aspects of efficiency gains/clean energy transition/physical changes incorporated into scenarios and business planning?
Geographical tailoring of transition impacts – what assumptions does the organization make about potential differences in input parameters across regions, countries, asset locations, and markets?
Technology – does the organization make assumptions about the development of performance/cost and resulting levels of deployment over time of various key supply and demand-side technologies (e.g. solar PV/CSP, wind, energy storage, biofuels, CCS/CCUS, nuclear, unconventional gas, electric vehicles, and efficiency technologies in other key sectors including industrial and infrastructure)?
Policy – what are assumptions about strength of different policy signals and their development over time (e.g. national headline carbon emissions targets; energy efficiency or technology standards and policies in key sectors; subsidies for fossil fuels; subsidies or support for renewable energy sources and for CCS/CCUS)
Climate sensitivity assumptions – assumptions of temperature increase relative to CO2 increase?
Scenarios – what scenarios does the organization use for transition impact analysis and which sources are used to assess physical impact both for central/base case and for sensitivity analyses?
Quantitative vs. qualitative or “directional” – is the scenario exercise fully quantitative or a mix of quantitative and qualitative?
Timing – how does the organization consider timing of implications under scenarios e.g. is this considered at a decadal level 2020; 2030; 2040; 2050
Scope of application – is the analysis applied to the whole value chain (inputs, operations and markets), or just direct effects on specific business units / operations?
Climate models/data sets – which climate models and data sets support the assessment of climate-related risks?
Physical risks – when assessing physical risks, which specific risks have been included and their severity (e.g., temperature, precipitation, flooding, storm surge, sea level rise, hurricanes, water availability/ drought, landslides, wildfires or others)? To what extent has the organization assessed the physical impact to its portfolio (e.g. largest assets, most vulnerable assets) and to what extent have physical risks been incorporated in investment screening and future business strategy?
To what extent has the impact on prices and availability in the whole value chain been considered, including knock on effects from suppliers, shippers, infrastructure, and access to customers?
Earnings – what conclusions does the organization draw about impact on earnings and how does it express that impact (e.g. as EBITDA, EBITDA margins, EBITDA contribution, dividends)?
Costs – what conclusions does the organization draw about the implications for its operating/production costs and their development over time?
Revenues – what conclusions does the organization draw about the implications for the revenues from its key commodities/ products/ services and their development over time?
Assets – what are the implications for asset values of various scenarios?
Capital Allocation/ investments – what are the implications for capex and other investments?
Timing – what conclusions does the organization draw about development of costs, revenues and earnings across time (e.g. 5/10/20 year)?
Responses – what information does the organization provide in relation to potential impacts (e.g. intended changes to capital expenditure plans, changes to portfolio through acquisitions and divestments, retirement of assets, entry into new markets, development of new capabilities etc.)?
Business Interruption due to physical impacts – what is the organization’s conclusion about its potential business interruption/productivity loss due to physical impacts both direct effects on the organization’s own assets and indirect effects of supply chain/product delivery disruptions?
Organizations should carefully consider the key parameters, assumptions, and other analytical choices made during scenario analysis as well as the potential impacts or effects that are identified and how those results are considered by management.
In particular, organizations are encouraged to disclose the approach used for selecting scenarios used as well as the underlying assumptions for each scenario regarding how a particular pathway might develop, e.g. emergence and deployment of key technologies, policy developments and timing, geopolitical environment around climate policies.
Importance of transparency
Transparency around key parameters, assumptions, and analytical choices will help to support comparability of results between different scenarios used by an organization and across organizations.
In turn, this will support the evaluation, by analysts and investors, of the robustness of organizations’ strategies across a range of plausible impacts, thereby supporting better risk and capital allocation decisions.
Variability vs. Comparability
Given the number of variables and analytical approaches to scenario analysis, there can be a wide range of scenarios that describe various outcomes. Given this, direct comparability across organizations is likely to be a very real challenge. This underpins the importance of transparency across the three categories of considerations.
4. Tools and Data
Portals with a range of tools and data
- IIASA provides a variety of land, energy, transition, and water tools as well as online databases, including for energy, GHG mitigation strategies, and climate policies consistent with 2°C and IPCC scenarios
- CLIPC provides access to climate information of direct relevance to a wide variety of users
- It is a “one-stop-shop” platform that allows you to find answers to questions related to climate change and climate impact
- It includes data from satellite and in-situ observations, climate models, data re-analyses, and transformed data products enabling assessment of climate change impact indicators
Topic- and/or sector-specific tools
- The World Resources Institute (WRI) built a tool/database to help companies, investors, governments, and communities better understand where and how water risks are emerging around the world
- The U.S. Environmental Protection Agency (EPA) provides a tool known as the Climate Resilience Evaluation and Awareness Tool (CREAT)
- It is a risk assessment application for utilities in adapting to extreme weather events through a better understanding of current and future climate conditions
- The U.S. EPA also provides tools and guidance for water utilities called Creating Resilient Water Utilities (CRWU)
- It provides water utilities with practical tools to increase climate change resilience and understand long-term adaptation options
- Best Practices and Case Studies for Industrial Energy Efficiency Improvement
- United Nations Food and Agricultural Organization’s Modelling System for Agricultural Impacts of Climate Change
Resources to get you started
- Investing in a time of climate change
- Preparing Portfolios for Transformation
- Investor primer to transition risk analysis
- World Energy Outlook Model
- Climate Change Scenarios – Implications for Strategic Asset Allocation
- Climate Scenarios: What we need to know and how to generate them
For more resources, search here.