Uncertainty is intrinsic to climate change. While the realities of the
phenomenon are becoming increasingly apparent with each passing season, it is
not clear just how fast or in what ways that change is occurring.
In the midst of such uncertainty, there is growing pressure on the global
financial sector — from a regulatory, fiduciary and societal perspective — to
understand its implications; doing so will allow financial institutions to
manage their exposure to these long-term impacts by integrating climate change
into the investment process.
Financial institutions are turning to climate-scenario analysis to identify
climate change-related
risks
and opportunities to manage their exposure. Climate-scenario analysis considers
a range of possible future climate pathways — as well as associated economic and
market developments — to help financial institutions to identify and evaluate
climate-related financial
risks
that may arise from a changing environment. It facilitates a structured
exploration of how certain climate-related financial
risks
could manifest for financial institutions – including pension
funds,
insurance
companies,
sovereign wealth funds, asset managers and banks – and their investment
portfolios in the future.
Financial institutions considering utilizing climate-scenario analysis several
options:
-
drawing on publicly available scenarios developed by the Network of
Central Banks and Supervisors for Greening the Financial System
(NGFS);
-
purchasing alternative scenario sets that are developed using different
modelling methodologies and assumptions; and
-
developing their own bespoke scenarios to reflect their own specific
views and assumptions.
The diversity of scenarios is creating confusion in the market as to how
investors can select the most appropriate ones to achieve their objectives.
The most widely utilized of these are the publicly available scenarios. The free
accessibility of this category has made them successful in increasing awareness
of the need to manage climate-related risks and opportunities, and also of the
effectiveness of this tool in supporting long-term investment decision-making.
However, the one-size-fits-all nature of publicly available scenarios poses many
pitfalls, not least of which include herd mentality and a lack of diversity of
opinion. If left unchallenged, this could become a driver of systematic climate
risk.
This could be avoided by relying on a more diverse range of climate scenarios
that are more representative of real-world dynamics and assumptions. Financial
institutions could look to bespoke scenarios, which do offer greater flexibility
and granularity in incorporating specific views and detailed assumptions that
are representative of an institution’s operating context. However, these models
are resource-intensive and can be complex and time-consuming to develop.
Against this backdrop, alternative scenarios offer the most feasible option for
financial institutions — particularly those that are resource-constrained but
are seriously committed to addressing climate-related risks and opportunities
within their investment process. Offered by specialist
firms in a third-party capacity, alternative
scenarios are off-the-shelf solutions that provide a more comprehensive range of
parameters that can be used to supplement the publicly available scenario sets.
Increased availability of a wide range of climate scenarios, as long as they are
plausible, can only be a positive influence in steering financial institutions
away from group think and reducing the long-term financial risks of climate
change.
To learn more about climate scenarios, download Ortec Finance’s latest whitepaper.
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Andrew Flynn is Director of Climate & ESG Solutions at Ortec Finance — a leading global provider of technology and solutions for risk and return management.
Published Aug 7, 2023 8am EDT / 5am PDT / 1pm BST / 2pm CEST