Climate Scenario Analysis

Climate Scenario Analysis

On the Transition Monitor platform, individual users can perform a PACTA analysis of their portfolios. It is important to bear in mind that the tool will be able to perform the analysis on the financial assets that the tool for investors covers, such as long positions in listed equity, corporate bonds, and funds. PACTA bases its assessment of portfolio alignment to a climate scenario on forward-looking production values, which are measured in economic units of output in the real economy. It is thus distinguished from carbon accounting frameworks, which are often based on historic data. For additional information on the PACTA methodology, please refer to the PACTA for Investors methodology document.

Measuring alignment requires scenarios that explain what needs to happen in a sector to decarbonize. While climate change scenarios don't predict the future, they provide essential information to understand climate change and the pathways to reach specific goals. It is important to note that climate scenarios are built using a range of different assumptions and, therefore, can propose different courses of action to achieve climate targets, so it is important to compare and contrast them. Not all scenarios cover all sectors, as such different sectors might also be analyzed using different scenarios.

Climate scenario analysis can help financial institutions assess and ultimately manage the risks and opportunities associated with the transition (i.e. "transition risk"). Scenarios represent potential technologies pathways to reach e.g. climate targets. While being based on the best available scientific research, there remain uncertainties around the outcomes. Furthermore, different scenarios/pathways can lead to the same climate target depending on technology beliefs and preferences, as well as economic, social and other assumptions, etc.

Available Scenarios

The TCFD grouped climate-related risks into two categories: physical and transition risks.

• Transition risks are generated by the policy, technology, market, and regulatory changes likely to accompany the transition to a low carbon economy.

• Physical risks are direct and indirect impact climate change on labour and operations, physical assets, supply chain, distribution chain, consumers, and the communities on which companies depend. Examples include property damage due to flooding, reduced water availability due to increased demand from others and extreme weather events.

Scenarios may differ on the following factors:

• The speed at which decarbonisation occurs'

• Availability of technologies, scalability and cost;

• Favouring or ruling out different technologies (e.g. phase-out of nuclear in the Energy Revolution scenario, prominent use of CCS in the B2DS scenario)

• Level of ambition for decarbonisation (resulting in varying likelihoods of limiting the global average rise in temperature to <2°C)

• Levels of granularity (time, geography, etc.)

Limitations and Assumptions

As we have already emphasized, scenarios and their sectoral pathways are still only depictions and models of possible futures. When conducting scenario analysis on a portfolio it is therefore important to understand the following limitations and assumptions:

- Probability of achieving the stated goals

The estimated degree Celsius number connected to climate scenarios is usually accompanied by the probability of stabilizing global warming at the degrees Celsius target above pre-industrial levels by 2100. Thus, aligning with a 2°C scenario may represent, for example, a 50% chance and thus doesn't necessarily lead to the limiting of global warming to 2°C.

The use of a given scenario (B2DS, SDS, NPS, CPS) does not constitute an assumption that this scenario is more likely to prevail than others, but the assumptions made about the market maturity of the different technologies in the pathways can provide an overall indication of the degree of uncertainty.

- Understanding the assumptions around available technologies

Some scenarios rely on technologies which are still in the development phase and hence may not be available at the speed and scale that the scenario requires. For example, the IEA 2°C scenario relies on a significant portion of BECS (Bio energy with Carbon Storage) after 2050, but there are still open questions regarding its technological feasibility.

On the other hand, past IEA scenarios have been quite conservative. They have underestimated both energy efficiency developments and renewable deployment rates (as a result of accelerated reductions in the cost of technologies). This means that the scenarios might not be ambitious enough (compared to what is feasible) and that there is a need for more ambitious scenarios that lead to higher probabilities to limit global warming to well below 2°C, one of the main goals of the Paris agreement.

- Different scenarios are underpinned by different modeling assumptions

Scenarios are not future projections, they are estimations and are based on numerous indicators and assumptions, which might not all hold true and will depend on the beliefs of the publishers of the scenarios. Hence, it is important to understand the underlying assumptions behind the scenarios being used.

For more information related to the climate scenarios, please refer to the PACTA for Investors - Scenario supporting document