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Finance & Investment
What Is the Role of Climate Scenarios in the Investment Process?

Increased availability of a wide range of plausible climate scenarios can help steer financial institutions away from group think and reduce the long-term financial risks of climate change.

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]/read/finance-investment/water-risk-is-a-financial-risk-companies-will-soon-have-the-tools-to-calculate-disclose-and-mitigate-it) 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:

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    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.