How to quantify the financial impacts of climate change

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Climate scenario analysis helps financial institutions understand how different climate futures could affect investment portfolios, writes Andrew Flynn.

Climate change is already a reality. What has yet to be determined is how, and to what extent, the physical transition and market risks associated with climate change will affect economies, financial institutions and investment portfolios over the short and long term.

As our future climate becomes increasingly uncertain, it is vital that major financial institutions that collectively manage the world’s purse strings proactively and effectively quantify the financial impacts of climate change so that they can be adequately prepared for its potential effects.

Climate scenario analysis (CSA) is now recognised as a critical tool to systematically examine plausible future climate-related outcomes*. While not a forecasting tool, a credible CSA which covers key economic and financial metrics, such as GDP, inflation and asset-class risk and return, helps financial institutions understand how different climate-related outcomes could manifest and impact investment portfolios.

By analysing different climate scenarios, financial institutions can identify an array of risks and opportunities associated with specific climate futures, enabling them to make informed decisions and take appropriate actions.

Given the value of this approach for climate-related risk management, there is now a wide array of climate scenarios available in the market, drawing on a range of models and inputs. Choosing a suitable approach for a CSA is not only essential to ensure insights are reliable and credible, but also that they are tailored to the needs and the context of the business or investment in question.

Five critical elements

Five elements are critical to ensuring a CSA is suitable for generating financial insights to support strategic asset-allocation decisions and for stress-testing purposes.

1. Incorporate a comprehensive range of plausible climate pathways that reflect uncertainties in climate change, global regulations and policies, and the use of technologies to mitigate climate impacts.

2. Ensure thorough coverage of transition, physical and market risks – that is the impact of transitioning to a low-carbon economy, the physical effects of climate change and how financial institutions price these risks in and respond to market shocks.

3. Use a top-down approach, which is critical for understanding the effects and magnitude of climate-related risks, while allowing for granular modelling at country, sector and asset-class levels, to provide actionable financial insights.

4. Draw on simulation models that realistically reflect the speed of change, and account for limiting factors and constraints under hypothetical climate scenarios.

5. Ensure any views or assumptions are plausible and realistic, so that the results are valid and informative, with the option to test projected impacts through sensitivity analysis.

These five elements are critical for drawing useful insights from a CSA. While it is important to stress that there are limitations and caveats associated with any model, the insights gained can still be of considerable value for making informed investment decisions and adapting to an uncertain future.

*Climate Scenario Analysis by Jurisdictions: Initial findings and lessons, Financial Stability Board (2022)

Andrew Flynn is director of climate and ESG solutions for EMEA at Ortec Finance

To learn more about climate scenarios, download Ortec Finance’s latest white paper

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