Scenario analysis has dominated the climate finance conversation since the Taskforce on Climate-Related Financial Disclosure (TCFD) integrated it as a core strategy in its 2017 recommendations report. The risk-focused exercise may have strategic benefits for companies trying to comprehend the redirection of assets and capital that is needed, but Preventable Surprises, r3.0 and IEECP hold that this is insufficient, of limited use, and sometimes misguided. Instead, investors would be better advised to focus on transformation plans.
Kate McKenzie’s recent article, “The Trouble with Climate Change Scenarios is That Everyone Has Their Own” confirms our thinking.
Her solid critique shows the value of scenario analysis as a tool for managing climate-related physical or transition risks. Clearly it can have a powerful educative impact if corporate leadership is of a mind to make use of that information, as BP’s recent announcements seem to indicate.
At the same time, building scenarios has huge potential to be yet more procrastination or even predatory delay if not followed by decisions and actions. For example, Shell has developed state of art scenarios for decades, but their real-world application – and benefits – remain unclear.
Climate scenarios have also created a mini industry, where success depends on producing, updating, refining, and auditing scenarios under loose regulation: the specialists who produce and analyze the scenarios rarely have decision-making power, and those who do have such power often lack the technical understanding of the process – and more importantly, the will to disrupt their own financial incentives in the status quo. For many, scenarios have also become just one more way of kicking the climate can down the road, rather than acting with the required urgency.
Scenarios, as the article points out, are a complex affair. Indeed, research on Shared Socioeconomic Pathways is evidence that climate scenarios remain almost incomprehensible and/or far too hypothetical to the rest of society. It also shows how those different pathways can radically impact the possibility and success of climate mitigation over the coming century, as well as how bad the situation will be unless we act quickly and decisively. Paris Reinforce, an EU funded Horizon 2020 project is collating and comparing nineteen models to try and bring transparency to their assumptions, underlying factors and mathematical machinery, as well as to bring the scenario modeler community into a more pragmatic and action-oriented dialogue.
Lastly and arguably most importantly, assessing the resilience of assets and portfolios in the context of these scenarios may turn out to be a futile exercise. IEA scenarios have notoriously underestimated the pace at which solar and wind became cheaper and fail to account for Paris Agreement compliance. Also, who can really claim to be able to properly estimate the social (forced migration, hunger, inequalities), environmental (catastrophic biodiversity loss), political (populism, failed states, corporate capture) and economic (catastrophes, public finances, global trade) disruption? As far as climate is concerned, all scenario analysis dating back to the Stern report – turning the table on the earlier DICE modeling results of economically “ideal warming” by Nobel-laurate William D. Nordhaus – consistently shows that inaction is costlier than action. Even the DICE model, when updated, shows the economic benefit of 2°C, so why wait?
This is why climate aware investors and companies need to recognize the limitations of a risk planning exercise with too many parameters, in order to focus on transformation plans, now that a gentle transition is out of reach. What that transformation looks like, whether a shift to different lines of business (e.g. renewables, hydrogen and or Carbon Capture and Storage in the case of fossil fuel companies) or returning money to shareholders – or a mix of both – is up to the companies to propose and investors to evaluate. The bottom line is that there needs to be a radical shift away from the extraction, distribution and consumption of fossil fuels, and similar shifts in other emissions-driving sectors like agriculture, housing, and transportation.
Scenario planning describes a possible future, it does not create a plan. The thing about climate change – and its devastating consequences – is that it is happening now, with radical implications for the economy and that the positive impacts of serious mitigation will take decades to materialize.
Business will transform no matter what. The only question is how quickly and at what cost to society. Investors who sit back and watch it happen, no matter how many scenarios they have drawn, will fall short of addressing the systemic climate risk. They need to take a much more proactive stance.
Clearly it is time to move beyond scenario planning. Preventable Surprises has long advocated for industry transformation plans, alongside r3.0 in their Sustainable Finance Blueprint, and others. There has been pushback in the past, mostly from large US asset managers and even from associations of climate aware investors who were, we can only assume, not wanting to expose their slowest moving members. But continuing on this path will hurt investors and their clients, hurt companies, and hurt human society and the environment.
We are not alone in making this call. Mark Carney, the former Governor of the Bank of England and former Chair of the Financial Stability Board which launched TCFD and current United Nations Special Envoy for Climate Action, is now openly calling for “disclosure of transition plans by companies” because “it is about every part of the economy adjusting.”
The Institutional Investor’s Group on Climate Change’s new draft Net Zero Investment Framework also requests “a credible investment plan or business model for achieving targets”, “revenues and capital expenditure consistent with achieving targets”, “clear governance responsibilities for targets and transitioning”, and “executive remuneration linked to delivering targets and investment plans”.
To pivot from scenarios to transformation, investors should take the following steps:
- Investors should make clear that they expect to see all high impact sectors (e.g. energy utility companies, infrastructure, transport, agri-food) and highly vulnerable sectors (e.g. real estate) publish – and then enact – transformation plans as a matter of urgency.
- Climate aware investors need to send top down signals that they will, in general, support resolutions calling for transformation plans, and if these are blocked, will vote against recalcitrant chairs or entire boards.
- Investors should acknowledge the limits of collaboration: it is often hampered by the lowest common denominator and encourages freeriding. The larger asset managers are unwilling participants and they generally avoid the more demanding issues such as remuneration and lobbying. Better: clients and stakeholders should push the largest investors to take on one or two sectors each, creating accountability. Smaller managers can focus on asking the tough questions which others are seemingly unable to. This is a radical departure for how the ESG community can work together but it is a necessary one.
Time is of the essence. The climate emergency requires action today in the form of transformation. Transformation will take care of managing risks, but the converse is not true. For all investors and stakeholders who are genuinely concerned about climate, or look at the climate playbook as a model for other interventions on systemic risks such as biodiversity loss, the stark lesson is that data, disclosure and scenarios don’t produce intention, action , or adequate regulation. And with so much uncertainty on what and when regulation might emerge, investor and corporate action is an immediate must.
We hope others will join in this crucial call to action to the financial sector.
Bill Baue, Senior Director, r3.0
Zsolt Lengyel, Chairman, Institute for European Energy & Climate Policy
Jérôme Tagger, CEO Preventable Surprises