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Threadneedle Street Points to Importance of Scenario Analysis

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Sarah Breeden, the Bank of England’s executive director for sustainability, last week called on all stakeholders to redouble efforts to curtail global warming, singling out the banking and insurance sectors as key pillars of change.

In her grim assessment of the lack of progress in the achieving global climate targets so far, she outlined four “core dimensions” for pulling the global decarbonisation goal back on track. Top of her list was the use of scenario analysis to help plot the course – and remediation of – future climate risks.

Scenario analysis is a tool that investors have adapted to assess the vulnerability of their investments to risks that could arise as temperatures rise. The Bank of England deployed the technique in its bank stress tests in 2021, when it sought to divine climate-related risk exposures in lenders’ portfolios and bank books.

The Climate Biennial Exploratory Scenario CBES), which concluded in 2022, “was transformative, both in shining a light on otherwise opaque risks and in building capabilities”, Breeden told a gathering of finance leaders in London. “Importantly, the exercise required firms to understand how their real economy customers were both exposed to these risks and the actions they would take to manage them. It revealed gaps in real economy firms’ understanding of what climate transition means for them.”

Forward-Looking

Scenario analysis is popular among financial institutions’ research departments because it is a forward-looking tool that uses present-day and historical data to assess what might happen under a particular set of circumstances in the future. It simulates hypothetical situations that challenge conventional assumptions. In this way, institutions can plot risk-management strategies for a variety of possible outcomes.

Analysts have long deployed it to test potential outcomes in a range of disciplines. Banks, for instance, regularly use stress tests to model their resilience to potential financial shocks. The results have led to new regulations requiring them to boost their capital buffers.

But the utility of scenario analysis to ESG investors has been recognised more recently by data providers including Beringa, Bloomberg and MSCI, who offer products based on such analyses to their ESG customers.

Their products seek to help clients identify vulnerabilities to two types of climate risks: physical risks that arise from changes in the climate, and which might include floods, violent storms and severe heat; and transition risks, which arise from switching to a carbon-neutral strategy. The latter category could include risks to energy supplies and reputational risks as stakeholders demand greater transparency into companies’ transition pathways.

The importance of this form of analysis has been noted recently by the broader financial and ESG sectors.

“Scenario analysis is increasingly used by asset managers, and the wider investment community, as a tool to inform decision making, strategy setting, risk management; as well as to develop an approach to disclosure of the climate-related risks and opportunities,” the UK’s regulator, the Financial Conduct Authority (FCA), wrote in a paper earlier this year.

ESG data company Persefoni has gone further, saying the tool “is a necessary part of building a climate strategy”.

The Taskforce for Climate-related Finance Disclosures’ (TCFD), one of the most commonly used frameworks for companies and institutions to report on their ESG performance, encourages the use of scenario analysis because it helps organisations “explore alternatives that may significantly alter the basis for ‘business-as-usual’ assumptions”.

New Models

Scenarios can be modelled qualitatively to capture developments that can’t be expressed numerically, such as geopolitical changes within the macro sphere, or corporate governance developments at the micro scale. The models can also be quantitative, using hard-and-fast data on – for instance – carbon emissions and financial performance. For climate analyses, however, the models  need to combine the two.

MSCI used scenario analysis to create its Corporate Sustainability Insights (CSI) tool that enables companies – and investors – to track their own ESG- and climate-related performances.

“We’ve developed a lot of climate metrics in scenario analysis to help companies and investors have a common language on how they should be analysing their performance,” MSCI global head of corporate ESG and climate solutions Beth Byington told ESG Insight.

The application of scenario analysis to climate risk research is still in its early days. Creating the scenarios and identifying the factors that need to be built into the models requires more work than goes into a straight-forward banking financial stress test. They need granular data on a broad range of inputs to be accurate.

The need for institutions to shore up these capabilities soon may no longer be moot as scenario analysis is likely to be required by regulators in the coming years. Already overseers are encouraging the adoption of these tools in institutions’ armouries.

Earlier this year, for instance, the FCA’s Climate Financial Risk Forum published a detailed guidance paper on how asset managers can embed scenario analysis into their ESG processes. And the Securities and Exchange Commission has recommended the use of scenario analysis in the US regulator’s proposed climate disclosure rules.

Whether regulators impose it on them or not, institutions will almost certainly be left out in the cold if they don’t integrate such analyses into their systems. That’s especially so, considering that the International Sustainability Standards Board, which is widely expected to provide the basis for a streamlined set of global disclosure rules, has said it would require scenario analysis in its eventual framework.

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