Climate change is widely considered to be one of the most significant global risks to society and economies. However, many institutional investors find it difficult to quantitatively assess what financial impact climate change could have on their portfolios.
Climate scenario analysis offers a methodical way forward, according to the Morgan Stanley Institute for Sustainable Investing’s new report, “Integrating Climate Scenario Analysis into the Investment Process.” With the right data and models, institutional investors can better quantify the economic effects of climate change in the same way that they currently analyze the potential impact of market signals and economic indicators.
Investors have shown interest in using this nascent method to map climate-related uncertainties. An Institute for Sustainable Investing survey found that while more than half of asset owners want asset managers to conduct climate scenario analysis, less than one-third provide it. At the same time, investors are also increasingly expected to conduct climate scenario analysis to meet disclosure expectations, such as the Taskforce on Climate-related Financial Disclosures (TCFD), and even certain regulatory requirements.
What Is Climate Scenario Analysis?
At present, the impact of climate change on portfolios is difficult to measure and predict accurately. The understanding of climate science itself is constantly evolving in response to new data, and investment horizons are typically much shorter than climate impact timescales. As a result, it can be challenging to relate non- financial factors such as greenhouse gas emissions directly to financial outcomes.
Using specialized computer models, climate scenario analysis assesses the impact of future events, to help investors understand related risks and opportunities. Quantitative climate scenarios are the best way to explore the connections between environmental factors (e.g., greenhouse gas emissions) and financial factors (e.g., gross domestic product, carbon prices and energy prices).
Consider two possible climate futures:
Temperatures increase by 1.5°C or well below 2°C above preindustrial levels, resulting in greater transition risks (financial or reputational) to businesses as they decarbonize; or
Temperatures increase by 3°C or more from preindustrial levels, resulting in greater physical risks such as sea-level rise, catastrophic weather events and loss of arable land.
Each of these scenarios would yield different political, social, technological and environmental considerations and outcomes. As a result, the global economy and market conditions in each scenario would differ. For climate scenario analysis in portfolios to be effective, investors must define a reasonable range of scenarios, supported by data, models and reliable practices, with the aim of assessing the impact on portfolios.
4 Steps for Climate Scenario Analysis
Climate scenario analysis can be categorized into four main stages:
Set the question. First, investors need to define what question they want to explore. This will inform how the scenarios are constructed, which variables need to be tested or held constant, and the required outputs.
Build the scenarios. Investors can either choose pre-defined scenarios provided by organizations such as the Network for Greening the Financial System (NGFS) or build their own custom scenarios, which offer more nuance and control but are more complex and require a greater understanding of climate science.
Conduct analysis. Mathematical computer models—usually Integrated Assessment Models (IAMs)—draw the relationship between greenhouse gas emissions and social and economic factors. If an investor uses scenarios from organizations like NGFS, then this analysis will already have been completed; for custom scenarios, investors would run this analysis themselves with input from experts who understand how IAMs work.
Use outputs. Outputs can be used directly to inform portfolio risk analysis or bottom-up company analysis. Potential outputs could include prices for energy, carbon and other commodities, as well as imports/exports, emissions, supply/demand volumes and land use.
The resulting outputs can then be used to analyze portfolio impacts for overall climate change risks. This can take the form of bottom-up company analysis or top-down macroeconomic analysis, generating estimates on factors such as bond yields, inflation or index prices.
At each stage, investors may need to find a balance between competing priorities. Most notably, limited resources may constrain the level of detail that can be built in. Some of the challenges involved in using climate scenario modelling based on constantly evolving understandings of climate science cannot yet be resolved, and so the impact of physical risks, such as flooding, may be structurally understated in models. However, most challenges can be managed.
Case Study: Carbon Capture and Pricing Scenarios
Morgan Stanley applied its in-house climate scenario capabilities to a case study that examines two scenarios related to the availability of carbon capture and storage (CCS), an emerging technology used to remove CO2 before, during or after the combustion of fossil fuels or biomass. The International Energy Agency (IEA)1 forecasts that meeting global net-zero targets requires a significant contribution from innovative technologies such as CCS, which is widely used in climate scenario analysis, but has yet to live up to its promise because of high costs and challenges with scale.
We considered two scenarios: CCS technologies being able to remove either 23 or 15 gigatons of carbon from the atmosphere by 2050, with other variables such as population, GDP and government policy on emissions held constant. Analyzing these paths shows different outcomes for CO2 emissions, carbon pricing, primary energy mix and electricity costs. Taking the carbon price as an example, when CCS technologies can sequester 23 gigatons of carbon, the 2050 carbon price is approximately $750 per ton of CO2. By contrast, when CCS can only remove 15 gigatons, the carbon price shoots up to approximately $1,100 per ton of CO2, reflecting higher costs of CCS in the lower volume scenario.
This analysis could inform a range of potential portfolio outcomes, including long-term fossil fuel demand, the impact on earnings for companies in energy and beyond, energy consumption and household spending.
Quantifying Climate Impacts on Portfolios Despite Complexity
While climate change scenario analysis is a relatively new practice, it echoes how investors already assess the global markets and economy. Understandably, a constant stream of new climate change findings, data, policies, technologies and dynamics make risk assessment seem daunting. But climate scenario analysis can serve as a useful tool for institutional investors who want a methodical approach to understanding the potential impacts of climate change in their portfolios.