Using climate-related scenario analysis to assess climate resilience

Our sustainability webinar series aims to break the complex world of sustainability into digestible pieces to help you understand the fundamentals and start driving change in your organisation. At our August 2024 event, Aletta Boshoff discussed how organisations can use climate-related scenario analysis to evaluate their resilience to climate change. She emphasised the need for companies to integrate these analyses into their planning processes. 

Recap of requirements of IFRS S2 Climate-related Disclosures

IFRS S2 Climate-related Disclosures requires entities to disclose information about climate-related risks and opportunities that could reasonably be expected to affect cash flows, access to finance, or capital costs over the short, medium, or long term. The standard focuses on four core elements: governance, strategy, risk management, and metrics and targets.

Entities must disclose how their strategy and business model can withstand climate-related changes, considering identified risks and opportunities. To assess this resilience, they must conduct a scenario analysis.

What is a scenario?

In this context, a scenario outlines a development path leading to a specific outcome. It highlights key elements and factors driving future developments without fully describing the future. Scenarios are hypothetical constructs, designed to explore possibilities rather than provide forecasts, predictions or sensitivity analyses.

What is a scenario analysis?

According to the Task Force on Climate-Related Financial Disclosures (TCFD), scenario analysis is a strategic tool designed to enhance critical thinking. It challenges conventional wisdom about the future and explores alternative paths in a world of uncertainty, potentially altering the basis for “business-as-usual” assumptions.

Scenario analysis characteristics

Plausible	The events in the scenario should be possible and the narrative credible (i.e. the descriptions of what happened and why and how it happened should be believable).
Distinctive	Each scenario should focus on a different combination of the key factors Scenarios should be clearly differentiated in structure and message, not variations on a single theme Multiple scenarios should explore how different permutations and/or temporal developments of the same key factors can yield different outcomes.
Consistent	Each scenario should have a strong internal logic The goal of scenario analysis is to explore the way that factors interact, and each action should have a reaction Neither actors nor external factors should completely overturn the evidence of current trends and positions unless logical explanations for those changes are a central part of the scenario.
Relevant	Each scenario and the set of scenarios taken as a whole, should contribute specific insights into the future related to strategic and/or financial implications of climate-related risks and opportunities.
Challenging	Scenarios should challenge conventional wisdom and simplistic assumptions about the future When considering the major sources of uncertainty, scenarios should explore alternatives that will significantly alter the basis for business-as-usual assumptions.

Source: The Use of Scenario Analysis in Disclosure of Climate-related Risks and Opportunities - TCFD Knowledge Hub

Developing and applying scenario analysis

This step-by-step approach allows organisations to progressively build their expertise in scenario analysis, starting with basic qualitative assessments and moving on to advanced quantitative modelling. If you identify as a Group 1 entity under climate-related reporting guidelines, you should have already initiated your scenario analysis development.

Just starting	Begin with qualitative scenarios: Use narrative storylines to explore potential climate change implications Focus on helping management understand a range of possible futures.
Gaining experience	Incorporate quantitative elements: Develop quantitative pathways to illustrate potential outcomes Use data and quantitative information to enhance scenario narratives.
Advanced experience	Apply greater rigour and sophistication: Utilise comprehensive data sets and advanced quantitative models Benchmark against external third-party models or develop in-house modelling capabilities Ensure rigorous analysis to support strategic decision-making.

Source: The Use of Scenario Analysis in Disclosure of Climate-related Risks and Opportunities - TCFD Knowledge Hub

Considerations for building climate change into scenario analysis

Organisations should familiarise themselves with established scenarios, such as those from the International Energy Agency (IEA) and the Intergovernmental Panel on Climate Change (IPCC). These scenarios, widely used by scientists and policy analysts, help assess future climate vulnerability. They are built on estimates of future population levels, economic activity, governance structures, social values, and technological changes. They serve as “meta-scenarios” that provide a broad context and macro trends for developing specific company or sector scenarios.

However, these scenarios come with inherent assumptions and biases about future development paths, which do not cover the full range of possible futures. This limitation should be considered, especially when developing more disruptive scenarios.

Understanding the climate-related risks and opportunities to include in your scenario analysis

Each organisation faces a unique mix of specific climate-related risks and opportunities. The business impacts of climate change can differ greatly based on the industry and economic sector or sub-sector in which an organisation operates.

Potential factors influencing business impacts of climate change include:

• Geographic location of your value chain (both upstream and downstream)
• Assets and nature of operations
• Structure and dynamics of your supply and demand markets
• Customers and other key stakeholders.

The impact of market and technology shifts, reputational risk or opportunities, policy and legal changes and physical climate risks should also be built into the scenario analysis.

Analytical choices involved in scenario analysis

Entities must make a number of choices when conducting a scenario analysis. These include:

• Parameters and assumptions – the discount rate, carbon price, energy and demand mix, price of key commodities or products, macro-economic variables such as GDP and employment rates, demographic variables, efficiencies, technology and policy, and climate sensitivity assumptions
• Analytical choices – which scenarios to model, is the assessment quantitative vs qualitative or directional, what are the appropriate time horizons, is the analysis applied to the whole value chain or just specific business units, and which models and data sets to use?

The scenario analysis will then provide information for businesses to assess the effects on earnings, costs, revenues, assets, and capital allocation over the short, medium, and long term, as well as the entity’s intended responses (changes in CAPEX plans, divestments, new markets, etc.).

Resources to help you assess your climate resilience

Leveraging available resources is essential to effectively assess your organisation’s climate resilience. This process involves understanding and integrating climate-related risks and opportunities into your strategic planning. Start by exploring these reports:

• TCFD Final Report: Recommendations of the Task Force on climate-related financial disclosures
• TCFD Technical Supplement: The use of scenario analysis in disclosure of climate-related risks and opportunities
• Task Force on climate-related financial disclosures - Guidance on Scenario Analysis for non-financial companies.

By doing so, you’ll be better equipped to build a robust, resilient strategy that can withstand the uncertainties of climate change. BDO also specialises in evaluating climate risks and opportunities and can provide the necessary insights and tools to navigate a changing environment. Let us help you.