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7 Sins of Climate Scenario Analysis

Like medieval merchants clinging to flat-earth maps, today's businesses risk purgatory in a climate-changing world by misusing scenario analysis. Here are seven common mistakes that undermine climate scenario analysis, leading to poor strategic decisions.

1. The ‘climate as a standalone risk’ fallacy

Many businesses still treat climate risk as distinct from operational and regulatory risks, misrepresenting the challenge. Keeping things separate makes analysis easier on the surface but doesn’t reflect the reality that business value is inextricably linked to climate resilience. Climate change does not sit on the risk register — it reshapes it.

Treating climate as a separate risk also frustrates management action. If climate risk is treated separately, it invites the development of separate management actions and responsibilities. For example:

  • Climate-related business disruption might be addressed by the sustainability team, but other facility disruptions might be addressed by the operations team.

  • Regulatory changes on carbon pricing might be addressed by the sustainability team, but other regulations are addressed by the government relations team.

This is not an efficient way forward. When climate is seen as a driver of existing risk, the solution becomes clearer: It’s about the sustainability team supporting existing risk controls and equipping existing responsibilities with better information about the changes unfolding.

2. The 'average score' mirage

No one would say that the effects of a storm and a wildfire cancel each other out, but this is what we say when we try to create an average climate risk score. Consider the risk ratings for climate events across two sites:

Busy decision-makers looking for the answer will prioritize investment in Site A over Site B based on the average climate risk score. Is this the right call? Probably not.

At Site B, storm and heatwave risks could cause disproportionate financial damage due to their severity. People have written entire books about the importance of high-impact, low-probability events — Nassim Taleb’s The Black Swan being an example.

As Einstein said: “Make things as simple as possible, but no simpler.” Aggregate climate risk scores offer problematic simplicity. Acknowledging the diversity of climate effects leads to targeted insights for decision-making — which is the actual objective of scenario analysis.

3. Scenario analysis ≠ sensitivity analysis

Companies often perform sensitivity analyses, so it’s easy to assume that climate scenario analysis is just a sensitivity analysis on climate. Despite similar names, the two are apples and oranges.

In sensitivity analysis, a business tests the capacity of its existing strategy to withstand a challenge (such as a carbon price). Many companies have published climate scenario analyses that are, upon closer inspection, just sensitivity analyses.

It is a nuanced but important distinction for business resilience. Sensitivity analysis imputes the objectives of control and short-term efficiency — fundamentally at odds with scenario analysis’ goal of preparing for long-term resilience.

4. The baseline ‘no change’ fantasy

When considering future change, it is tempting to assume a “no change” counterfactual baseline for comparison purposes.

The Bank of International Settlements (BIS) concludes that “no change” scenarios are misleading for climate scenario analysis. They note that other baseline scenarios such as a warming of 3°C or a transition to a low-carbon society by 2050 are “more informed and realistic than the use of the counterfactual baseline, which assumes that neither climate change nor policy-driven transition will happen.”

This bears repeating: BIS considers that a low-carbon society by 2050 is “more informed and realistic” than a scenario assuming no change.

“No change” scenarios offer no value in scenario analysis — not even as a “baseline.” They imagine fantasy conditions that justify “staying the course” while change continues apace.

5. The ‘most likely’ delusion

Scenario analyses have been criticized because they don’t identify a “most likely” scenario. If no scenario is most likely, how are we supposed to plan for the future?

While “most likely” scenarios help plan for optimization, they do not support a company’s resilience. TCFD guidance does not suggest the use of a “most likely” scenario. The Network on Greening the Financial System doesn’t pick a “most likely” scenario.

The “most likely” scenario is sinful because it narrows decision-makers’ focus on a single predicted future, at the expense of others. Resilience is about preparing for uncertainty, including unlikely futures with high impact. A narrower focus encourages the type of thinking that scenario analysis seeks to avoid altogether.

6. The Goldilocks ‘central case’

Today’s GHG emissions and warming exceed the upper limit of projections from decades ago.

This doesn’t mean projections are useless for scenario analysis. Instead, it informs how we need to use them to guide decision-making. Climate scenario analyses should include a high-emissions scenario that assumes extreme (but plausible) warming, and a low emissions scenario that assumes a rapid (but plausible) low-carbon transition.

If we include a third, we need to be mindful of the sin of the “central case.” Once we’ve developed our high-emissions and low-emissions scenarios, a third scenario will land somewhere between the two extremes — inviting the assumption that there is a central-case scenario — one that seems like an average of the low- and high-emissions scenarios. Like the tale of Goldilocks, participants will gravitate to this central case as “just right” — a sensible scenario to plan for because it includes a bit of everything.

The opposite is true. Planning for a central-case scenario risks addressing neither the low-emissions nor high-emissions scenario.

When building scenarios that lie between the extremes, be sure to include something unique — such as a shock event. This helps additional scenarios offer something unique to the assessment and minimize the tendency for participants to discount the extremes.

7. The financialization fetish

Financial forecasting in scenario analysis is the ultimate case of substituting means for ends. The TCFD itself says that it isn’t looking for a financial forecast. Considering financial effects is a means to an end — a resilient company strategy.

Here’s an example that will remain anonymous but is publicly disclosed. A company noted climate-related reputational risks and estimated the financial impact: “Though there is no globally recognized approach to estimate such financial impact. The financial impact of 1% revenue was a consensus reached by experts after discussions and assessments.”

Investors care more about how companies manage reputational risk than about speculative financial estimates. This is what resilience is about. Offering a speculative financial forecast fails to demonstrate how resilient a company is to climate change.

Today’s sustainability reporting standards push back against the financialization fetish. The creators of the European Sustainability Reporting Standards clarify that when reporting on financial effects from climate change: "The intent is not to report the monetary amount of expected damage and loss ... which would be complex and uncertain to estimate."

Resist the temptation to deliver a precise financial forecast of future climate effects. It’s expensive, prone to accusations of fake certainty, and isn’t required. Instead, focus on the true purpose of scenario analysis — a comprehensive set of actions that enhance the resilience of your corporate strategy.