These days, companies are increasingly confronted with the term ‘scenario analysis’ in relation to climate-related risks. The Task-force on Climate-related Financial Disclosures (TCFD) recommends scenario analysis as a key element to stress-test a company’s strategy. Scenarios by organizations such as the International Energy Agency (IEA) and Intergovernmental Panel on Climate Change (IPCC) are making the headlines in the mainstream media to emphasize and demonstrate the future impacts of climate change. But what is scenario analysis and why is it valuable for your organization?
1. What is scenario analysis and why has it become a hot topic?
Scenario analysis is a tool to enhance critical strategic thinking
Scenario analysis, a process of analyzing future events by considering alternative possible outcomes, is a tool to identify sources of risk and opportunity that would normally go undetected. It provides a structured way to identify a range of potential long-term futures, allowing companies to understand the climate-related risks relevant to their business and how they may evolve over time.
Scenario analysis helps you maintain a long-term outlook (>10 years) and acknowledges the impact of volatile events, such as climate change, on organizations
Through this process, companies can then identify strategies to be resilient in these different futures. In contrast to risk management, scenarios typically focus on the long term and take uncertainty of the future as a given in reviewing risks and opportunities. They are characterized by answering ‘what-if’ questions, and thus do not aim to forecast or predict by assessing likelihood.
2. The value of scenario analysis: ‘future-proofing’ your company
1. Scenario analysis helps companies better assess key (long-term) climate risks by evaluating the impact of unexpected climate events on investment and other decisions.
Scenario analysis can be considered to be a form of risk management, but it challenges the conventional expectations about the future in ways that risk management does not. It has distinctly different characteristics, especially with regard to its long-term outlook (>10 years) and acknowledgement of the impact of volatile events, such as climate change, on organizations.
In traditional risk management, companies may not take into account systemic developments that are impacting a risk such as climate change; for example, a health pandemic, a drought that triggers geopolitical conflict, or an extreme weather event that damages a power plant and disrupts operations. While these types of events are not common at a global scale (yet), the damage inflicted can be incredibly high, if not much higher than the damage inflicted by a high probability event in any given year.
2. Scenario analysis helps companies better assess key climate opportunities. The process helps leaders build a vision of what might be possible in the future and allows them to identify opportunities their organization could start working towards today.
3. Scenario analysis helps companies comply with climate-related disclosures by mapping potential regulation in the future.
3. Where to start with scenario analysis?
Scenario analysis is sometimes placed in the same context as scenario modelling, financial modelling, or climate projections, which leads companies to quickly turn to quantitative figures to substantiate claims about the future, which is a common pitfall. It is, however, imperative to start qualitatively, by mapping out a few potential futures, and their risks and opportunities. A qualitative assessment can be equally as valuable as the financial model in an uncertain and increasingly dynamic world.
A few key steps to take before diving into the scenarios:
- Identify the purpose of creating scenarios: Many companies use climate scenarios to inform strategy; ensure the team is aligned on how the scenarios can be used.
- Identify the number of scenarios you would like to create: Start with a minimum of two in year 1 that are sufficiently distinct and build on complexity in the following years.
- Choose temperature trajectories for your scenarios: Decide whether your scenarios will reflect a world with a temperature rise of 1.5°C or one with a rise of well below 2°C.
- Select a time horizon: How far into the future will your organization be looking; 2030, 2040, or 2050?
- Don’t forget to leverage on existing scenarios: They can help to build your scenarios and inform predictions about the future.
How can KPMG help?
KPMG support clients in understanding the nature and scale of the climate-related risks and opportunities businesses face, in developing robust and insightful climate scenarios to understand the financial implications, and implementing the right strategy to mitigate climate-related risks and seize climate-related opportunities. We also support clients in making sense of the TCFD recommendations and the increasing number of climate-related regulations, in order to comply with regulations and to demonstrate companies’ ambition level. Our experts can guide you as you prepare your business to thrive in a low-carbon world.
Our support covers the following areas:
- Identifying climate-related risks and opportunities across the organization's supply chain.
- Developing and applying a range of climate scenarios to assess business resilience.
- Understanding business implications and impact on financial performance.
- Defining actions to mitigate and adapt climate-related risks and seize opportunities from climate change.
- Integrating climate risks in business and risk management processes.
- Assessing readiness for and improving TCFD and climate reporting to effectively communicate progress to stakeholders, such as investors.
Want to learn more on the value of climate scenarios and how to get started? Contact Anne-Cécile Moreno, Climate Risks & Decarbonization Lead.