Scenario analysis has been broadly recognized as an effective way of analyzing the potential impact of climate change on business strategy and investment risks. It has also been widely used in regulatory stress testing exercises and become a core component of nonfinancial disclosures. In addition to supporting many types of risk assessment, scenario analysis can form the basis to identify transition opportunities.
Repricing climate risks in financial markets and changes to climate policy are two major social factors that could have significant impacts across multi-asset portfolios. Both factors could become financial risks because we think markets have not adequately anticipated either of these outcomes despite a high probability that they are likely to occur. As such, investors should be prepared for significant changes in asset valuations driven by changes in climate expectations.
Using climate scenario analysis to identify transition risk opportunities
By analyzing two different climate scenarios — one above 2°C and one below 2°C — analysts can start quantifying the asset class impacts they might expect to occur. Comparing the two scenarios to a “climate underpriced” baseline, it is possible to identify both physical and transition risks. Figure 1 illustrates how this can be accomplished. By comparing each climate scenario with a baseline where climate is underpriced, it is possible to identify both physical and transition risks embedded in investments. For example, one can use broadly available climate scenarios such as those provided by the Network for Greening the Financial System (NGFS), translate them into a full set of either deterministic or stochastic financial scenarios, and then run the climate-conditioned scenarios through the asset and liability management (ALM) and risk management systems.
As illustrated in Figure 1, climate opportunities can also be identified as part of the process. Climate opportunities are often identified on a per holdings basis — for example, by looking at specific company equity that might be expected to perform well under a transition scenario. However, there is one issue with this approach: This type of investment requires the most significant capital outlay. Cost of capital constraints can put a ceiling on returns, even if demand emerges and holds up — for example, if the transition progresses as expected. More importantly, we can see in Figure 1 that a significant proportion of the transition opportunities may arise due to avoided physical risks across the broader range of portfolio holdings. Failing to take a wider portfolio view can potentially lead to hurdle rates for individual transition investments being set too high.
Climate analysts’ extensive experience working with climate scenarios in regulatory and discretionary exercises has also demonstrated that it is important to consider shorter-term risks that could emerge due to climate change. To date, much of the focus has been on modeling longer-term and fundamental uncertainties that are often difficult to adapt and respond to. This leads to a misalignment of the analysis with the horizon used in short-to-medium-term strategic plans.
Figure 1: Climate scenarios quantifying climate risks (physical and transition) and transition opportunities.
Figure 1 illustrates that the shift from a climate unpriced baseline to a pathway below 2°C — which would be consistent with the Paris Agreement — could potentially occur in two different ways. The shift might be direct, most likely triggered by a significant increase in the strength of global climate policy, including higher effective costs of carbon. An alternative route toward the outcome below 2°C could be indirect and market driven. This would involve a market correction triggered by concerns about high levels of physical risks followed by a response as markets shift to pursue increasing levels of climate opportunity.
Understanding the market correction is essential, but a broader perspective can be missed if the approach taken is strictly risk oriented. It becomes more challenging if the scenario analyses concentrate on just transitional or physical risk rather than integrating both consistently in all analyses.
It is helpful to recognize that fundamental uncertainty is substantially different from risk. One approach we recommend is exploring uncertainties using a systematic exercise insensitivity analysis starting with the simple comparison of two alternative climate scenarios — one analyzing physical risks and the other examining transition risks and opportunities. We can then see how different sources of uncertainty impact results while possibly iterating the core scenarios being used in the business. When pursuing this approach, it is important to consider the entire portfolio to balance the costs and savings associated with transition opportunities.
What can organizations do to unify their approach to climate risk management?
Typically, business functions that focus on risks, such as the Economic Capital and Own Risk and Solvency Assessment (ORSA) teams, are separated from those that focus on opportunities, such as the Strategy and Asset Allocation teams. The issue can be exacerbated if different teams use different scenario sources or core assumptions. The methodological approaches scenario providers take often favor one risk more than another. For example, climate scenarios produced by the International Energy Agency (IEA) and Principles for Responsible Investment (PRI) almost exclusively focus on transition dynamics whereas scientific sources such as the Coupled Model Intercomparison Project (CMIP) consortium focus exclusively on physical climate risks.
Financial institutions often treat transition and physical risk independently with entirely separate scenario sources. Given that the transition opportunity is a combination of both transition and avoided physical impacts, it is important to unite these efforts in a consistent assessment framework.
Nick Jessop, Senior Director, Insurance Solutions
Alasdair Thompson, Director, Insurance Solutions
Daniel Darwin-Clements, Director, Insurance Solutions
For more information on Moody’s Climate Scenario Modeling, please visit moodys.com/climate-risk-insurers or contact us today to schedule a conversation with our experts.
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Climate risk for insurers
Moody’s climate risk solutions empower insurance providers, brokers and reinsurers to assess interconnected physical and transition risk across the life, property and casualty markets.