What is Climate-related Scenario Analysis?
Scenario analysis is a process that businesses can employ to evaluate potential future events. In particular, climate-related scenario analysis focuses on events and futures related to climate change. The Task Force on Climate-related Financial Disclosures (TCFD) recommends all businesses utilize climate-related scenario analysis to explore how climate-related risks could affect their business and financial performance. Climate-related scenario analysis serves as a valuable tool, enabling businesses to anticipate the effects of climate change and other climate-related risks. This article will focus on the three proposed SEC disclosures that relate to climate-related scenario analysis.
In March 2022, the SEC released a document titled Fact Sheet: Enhancement and Standardization of Climate-Related Disclosures. This document includes proposed rules regarding disclosures related to “climate-related risks and their actual or likely material impacts on the registrant’s business, strategy, and outlook.” One of these disclosures would be for climate-related scenario analysis when “the registrant uses scenario analysis to assess the resilience of its business strategy to climate-related risks.” Required disclosures include:
- “A description of the scenarios used”
- “The parameters, assumptions, [and] analytical choices [that were used in the scenario]”
- “Projected financial impacts [of the scenario]”
For further information on the SEC Fact Sheet, see our article on the proposed standardization of climate-related disclosures for investors.
In addition to the three disclosures above, the TCFD recommends a list of disclosures that share relevant information with stakeholders. These include:
- How climate-related issues have affected business strategy
- Material climate-related issues
- Key performance indicators used to evaluate progress against climate-related targets
- Consideration of climate-related issues for major capital expenditures, acquisitions, and divestitures
Each of these additional disclosures provide needed context and perspective for stakeholders. Companies seeking greater transparency regarding climate issues should consider disclosing all information necessary to apprise stakeholders.
Description of Scenarios Used
Entities that use climate-related scenario analysis should disclose basic information regarding the scenarios used. This information should include:
- A description of the scenario narrative. Scenarios are hypothetical situations that describe a potential future. Explain the narrative of the particular future and the events that led to it to the stakeholders. Companies ought to explain the reasons for choosing the scenario.
- The timeframe of the scenario. Since scenarios depict possible futures, explaining the time period they cover is crucial. When considering multiple timeframes and selecting just one, clarify the reasons for preferring it over the others.
- The development process of the scenario. Companies should explain the origin of the scenario. Did the team create the scenario internally or externally? How many times did they revise the scenario? Were there any assumptions in the scenario that were controversial among those developing the scenario?
- Important constraints of the scenario. Entities that use scenario analysis should highlight any weaknesses or constraints of the scenarios employed. Companies should explain the limitations of scenario analysis and that it is not a prediction of future events.
The TCFD recommends, at a minimum, that companies adopt a scenario that prevents global temperatures from rising more than two degrees Celsius above pre-industrial levels. It also encourages companies to incorporate multiple scenarios in their analysis and to create company-specific scenarios that tackle their unique challenges. Companies should disclose the above-mentioned points for each scenario utilized.
Analytical Choices and Assumptions Used in Developing Scenarios
Creating a usable scenario requires significant amounts of data and judgment. The TCFD advises companies to disclose the resources employed and the internal decisions made when creating a scenario for analysis. This disclosure should include:
- Data sources used. Disclose the name and origin of any data sources used. Companies ought to justify their choice of data sources and describe the role each source plays in developing a scenario. For instance, if a company conducts a scenario analysis involving the impacts of extreme weather events, they should reveal that they obtained data from the National Weather Service due to its accuracy and reliability.
- Analytical choices made. Creating a scenario requires professional judgment. Stakeholders should receive disclosures of any analytical choices that require significant professional judgment.
- Important assumptions. Since scenarios are not predictions, creators will make assumptions that influence the scenario. Companies should disclose any assumptions they consider important to the scenario's outcome.
Disclosing data and assumptions provides more transparency to stakeholders that will help them understand the development of scenarios used.
Projected Financial and Other Impacts of Scenarios
One of the main goals of the SEC's proposed disclosures is the transparent disclosure of climate change's financial impacts. Two perspectives should guide the approach to the financial impacts of climate change:
- Physical Risks - The potential financial implications of the scenarios analyzed
- Transition Risks - The financial implications of changes in the company’s strategy due to climate change
Companies should first view the potential financial impacts of the scenarios analyzed and the physical risks associated with these scenarios. Climate-related events such as hurricanes, droughts, and rising sea levels will have financial impacts on companies. Entities that have important facilities located in areas prone to hurricanes should disclose the projected financial impact of losing those facilities. Companies should disclose the projected financial cost of relocation if they are based in locations that could be affected by rising sea levels. Companies should still disclose the underlying climate-related threat to stakeholders even if the risks are immaterial.
The second perspective that companies should consider are the financial implications related to changes in climate-related strategy, also known as transition risks. Transition risks are business-specific risks that emerge due to societal shifts towards a more environmentally friendly future. For example, there will be associated financial costs to install solar panels as companies choose to reduce their carbon footprint. The TCFD has identified four types of transition risks:
- Policy and Legal Risks. Regulations relating to sustainability are constantly changing. Companies operating in multiple states and countries must comply with different laws. The uncertainty regarding future regulations makes risks relating to policies a business risk. Companies that fail to comply with regulations could end up in legal trouble, another regulatory-related risk.
- Technology Risk. Changes in the climate will require changes in technology. Companies that can adapt will gain a strategic advantage, while those unable to develop new technologies may fall behind.
- Market Risk. Market risks include such broad topics as changes to supply and demand or increased costs for materials and services. Shifts in consumer preferences may favor companies that sell environmentally sustainable products.
- Reputation Risk. Public backlash may occur if companies appear unconcerned about climate change. Entities that resist adapting to climate change may face negative perceptions and financial consequences.
The TCFD also urges companies to disclose any future material climate-related issues. Most companies don't face immediate climate change threats, resulting in uninformative current disclosures due to immaterial present impacts. By explicitly disclosing potential future risks, companies grant stakeholders insights into the challenges they may encounter.
Climate-related scenario analysis is a powerful tool that companies can use to explore future possibilities. It enables companies to share potential climate-related risks with stakeholders while also sharing strategies to overcome them. Disclosures regarding the scenarios used, data utilized, and potential impacts of said scenarios are the current minimum standard that the SEC is looking to implement. Companies should prepare disclosures with the end user in mind, focusing on transparency and disclosing information that users find valuable.
TCFD, Scenario Analysis - https://www.tcfdhub.org/scenario-analysis/
Accounting for Sustainability, Climate Scenario Analysis - https://www.accountingforsustainability.org/content/dam/a4s/corporate/home/KnowledgeHub/Guide-pdf/A4S%20Guide%20to%20TCFD%20Climate%20Scenario%20Analysis.pdf.downloadasset.pdf
SASB, TCFD Implementation Guide - https://www.sasb.org/wp-content/uploads/2019/08/TCFD-Implementation-Guide.pdf?__hstc=105637852.c8aa5f78828a8ff22c16650ec62e93f8.1582824054969.1585058786292.1585132514669.7&__hssc=105637852.1.1585132514669
CDP, TCFD Scenario Analysis Guidance - https://assets.bbhub.io/company/sites/60/2020/09/2020-TCFD_Guidance-Scenario-Analysis-Guidance.pdf
CDP, TCFD Technical Supplement - https://assets.bbhub.io/company/sites/60/2020/10/FINAL-TCFD-Technical-Supplement-062917.pdf