Climate change presents unprecedented challenges for investors. Unlike traditional investment risks, climate-related risks are characterized by fundamental uncertainty and a lack of historical data. Pragmatic investors recognize that climate change poses a significant financial threat. To address this, they employ climate scenario analysis—a forward-thinking approach that simulates potential economic and financial impacts across different future scenarios. By doing so, investors can proactively understand unique risks, identify opportunities, and navigate unforeseen challenges.

To achieve a comprehensive understanding, climate scenario analysis must encompass a wide range of potential futures while remaining practically plausible. Although incorporating various assumptions and views is unavoidable when modeling ‘what-if’ scenarios under such uncertainty, three overarching principles enhance the plausibility of a deterministic narrative-based climate scenario.

Maintain a balanced tradeoff between climate transition and physical risks

Climate risk is commonly classified into two primary dimensions: firstly, the physical risk arising from the changing climate, including variations in temperatures and weather patterns; and secondly, the transition risk associated with the shift towards a low-carbon economy. The relationship between climate transition and physical risks is complex and exhibits strong and intricate interdependence.

Any abandonment, whether partial or full, of policies aimed at facilitating a transition to a low-carbon economy would likely lead to sustained or increased greenhouse gas emissions and rising temperatures. This exacerbates the severity of physical risks. In such a scenario, with low or limited transition efforts, the negative impacts associated with extreme weather events and loss of labor productivity would be heightened especially in the second half of the century.

Conversely, a policy-driven phase-out of fossil fuel technologies would logically entail the transition risk of assets linked to or reliant on coal, oil, and natural gas. However, economies and financial assets will stand to benefit from reduced physical risk impacts in the later years as the emission reduction limits the temperature rise.

Key takeaway – Plausible climate scenarios depict a relative and inverse relationship between transition and physical risks.

Be prudent when assessing climate change impacts

No forward-looking scenario will be an exact representation of how the future will unfold. Climate scenarios inherently involve high uncertainty, and the reality will be a variation of the modeled futures and their associated outcomes.

Climate change presents a fundamental uncertainty: the trajectory of the world's transition away from fossil fuels, the reduction of emissions, and the mitigation of rising temperatures remains unknown. This uncertainty is what we often refer to as a ‘known unknown’, and climate scenarios are crafted to shed light on these uncertainties through what-if scenarios. However, beyond this fundamental uncertainty lies an additional layer of complexity. There are ‘unknown unknowns’ such as climate tipping points, which are challenging to anticipate and even more difficult to model. These unknowns have the potential for severe consequences and are inherently fully captured by climate scenarios. 

An effective strategy to indirectly account for the potential effects of unknown unknowns in climate scenarios is to adopt a more prudent approach when evaluating the impacts of climate change's known unknowns. This will provide a more clear indication of both the direction and magnitude of economic and financial impacts, enhancing models ’ability to identify and address risks and opportunities more effectively.

Key takeaway – Plausible climate scenarios reflect the significance of unknown unknowns by utilizing a more prudent approach when assessing the impacts of modeled climate risks.

Incorporate realistic systemic responses to climate transition and physical risks

Certain impacts from different climate futures will be direct and more noticeable than others. Examples include increased economic losses linked to extreme weather event frequency and asset valuation and performance linked to low carbon policy implementation. It is important to not overlook the short and longer-term secondary effects stemming from realistic responses to the low-carbon transition and global warming. Increased temperatures that turn cities into being ‘unlivable’ could trigger mass migration and political instability. An enforced or societal-driven uptake of renewable energy may create significant growth for solar or wind energy producing countries. Lower market performance and asset devaluation could trigger market overreaction and pricing fluctuations. These systemic impacts can materially influence economies and assets globally. 
Key takeaway – Plausible climate scenarios anticipate and place due consideration towards ongoing realistic systemic responses to climate change.

Plausible climate scenarios drive better investment decisions

Plausible climate scenarios are vital to illustrating how climate change could realistically impact economies and assets under different futures. Scenarios that adopt a balanced tradeoff between climate transition and physical risks, prudent approach to assessing impacts and incorporate direct and indirect systemic responses will be better positioned to generate realistic and useful insights and enable more informed investment decisions. 

Translating the potential impact of climate change into financial metrics is crucial for informed decision-making. To delve deeper into this topic and learn how to undertake credible climate scenario analysis, download our whitepaper here Generating useful financial insights with a credible climate scenario analysis.


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