Scenario Analysis: An innovative tool for resilience in the face of the low-carbon transition
Scenario analysis has increasingly become a tool for companies to anticipate risks and opportunities, notably in the context of the low-carbon transition, but also as a relevant tool for internal and external mobilization – including with financial counterparts. Scenario analysis should therefore be seen as an effective tool enabling companies to internally assess their alignment with the objectives of the Paris Agreement; to confront their decision-makers and stakeholders with the uncertainties induced by the low-carbon transition and its socio-economic consequences; and to take appropriate strategic decisions.
Scenario analysis can be defined as a plausible representation of an uncertain future, built on the basis of hypotheses and parameters that are consistent with each other, that represent the result of underlying assumptions and modeling, and that serve as a tool for exploring the uncertainties of the future to support decision-making.
Policy Shift has conducted an analytical study of scenario analysis for climate-related purposes, as well as a specific case study in order to promote this innovative tool – which could be extended and deemed compulsory for large-size corporates.
Such work contributes to the Policy Shift Covid-19 and SDGs project, while also reinforcing links with partners or interested stakeholders.
Such work by Policy Shift aims to be furthered enhanced, notably by looking at broader environmental issues (i.e. natural capital) and social issues (i.e. the ones arising from the Covid-19 crisis, as well as topics relating to demographic aging, migration or the digital transition).
Scenario analysis is a key tool for companies to adjust to the difficulties associated with the low-carbon transition
Consequences raised by climate change and its impact on society have never been more significant, leading to profound changes in business activity, directly related to three key issues:
Firstly, the reconfiguration of the energy parameter has a clear impact for companies hitherto indirectly concerned by energy issues;
Secondly, the emergence of risks directly related to climate change (so-called transition risks and physical risks) has become e increasingly prevalent in certain key sectors, particularly in terms of impact and organizations’ adaptation and resilience to these risks;
Thirdly, the issues relating to the carbon budget are necessary to consider in light of the close relationship between the rate of greenhouse gas concentration in the atmosphere and the rise in average temperature, especially within the context of the setting of a temperature limit by the Paris Agreement (i.e. in addition to the issues relating to achieving carbon neutrality (under Article 4 of the Paris Agreement, corresponding to the balance between anthropogenic greenhouse gas emissions and their absorption by carbon sinks (soils and oceans)).
A series of examples confirms these findings, such as acute and physical risks (e.g. regular storms in Western Europe that can decimate arable land; more pest invasive); policy and legal risks (e.g. sharp increase in CO2 price); technology (e.g. influence of organic renders demand on agri-equipment) and markets evolutions (e.g. shift to localism and impact on agribusiness); as well as reputational issues.
Such issues are the source of a redefinition of the strategy of companies, which must and will henceforth have to deal with the need to reduce their vulnerabilities to environmental upheavals and take into account the fundamentals of a transition towards a low-carbon society, based on sobriety, efficiency and decarbonation. It is all the more important given that the low-carbon transition could be disorderly and uncertain, as exemplified by the "tragedy of the horizons" (defined by Mark Carney in 2015 as the gap between the perceived horizon of occurrence of climate risks and the management horizon of organizations - such “tragedy” delays action and therefore encourages the emergence of more brutal mitigation policies as compensation (ESRB, 2016)).
Important transformations required to reduce the consumption of fossil fuels within the productive system and the uncertainties inherent in the materialization of climate change and its associated consequences on natural and human ecosystems, including socio-economic consequences are also key elements to take into account. Moreover, the Covid-19 crisis has highlighted the consequences of climate and environmental upheavals on public health (Cavicchioli et al. 2019) and questioned companies’ capacity for resilience - justifying the implementation of a "culture of resilience" and climate change adaptation plans that integrate health issues.
These factors are therefore likely to have a significant influence on corporate profitability in the medium term, making it crucial for companies to be able to anticipate these changes (that are both sources of risks and opportunities) in order to build a successful and resilient corporate strategy.
This is why scenario analysis can be particularly useful to assess a company's resilience to the risks associated with the low-carbon transition – i.e. a “strategic foresight approach” as opposed to a more traditional “trend” forecasting approach that does not allow for a full grasp of the evolution of the business environment under the effect of the physical and socio-economic consequences of climate change. Taking this into account, the Task Force on Climate-related Financial Disclosure has given a central place to scenario analysis for strategic purposes as a key exercise to assess the robustness of organizations in the face of climate change. By producing a possible evolutionary path and constructing representations of possible futures, scenario analysis aims to guide strategic decisions without having to "predict the future" (I4CE, 2020) or provide a "comprehensive representation of the future" (Carbon 4, 2018).
What are climate scenarios?
Climate scenarios have been initially developed by the scientific community, based on the work of the IPCC, and structured around the definition of emission trajectories and concentrations of greenhouse gas (GHG), aerosols and other chemically active gases in the atmosphere (the Representative Concentration Pathways - RCPs), that constitute the input assumptions for modelling the evolution of the climate system. These assumptions are of four types: (i) a trajectory known as "RCP 2.6", which assumes a rapid reduction in emissions following a peak around 2020; (ii) two trajectories known as "RCP 4.5" and "RCP 6.0", both leading to a stabilization of emissions before 2100; and (iii) a trajectory known as "RCP 8.5", which leads to an increasing and sustained increase in emissions (the “business-as-usual” scenario). A fifth PCR (PCR 1.9) was developed by the IPCC in its Special Report on Warming to 1.5°C (2018) to explore emission and socio-economic development trajectories limiting global warming to 1.5°C compared to pre-industrial levels. Each of these trajectories is thus compatible with socio-economic scenarios - since a variety of socio-economic scenarios can result in a certain level of GHG concentration in the atmosphere.
The Shared Socioeconomic Pathways (SSPs) have also been standardized by the research community in order to help coordinate climate scenario modelling. They can be used to estimate how different levels of climate change mitigation (under the RCPs) could be achieved under a possible socioeconomic pathway. They are based on quantitative projections of three variables – GDP, population, and urbanization rate – as well as detailed narratives describing technological advancement, international cooperation or resource use, foreseen for a wide range of countries and regions, up to 2100. For instance, “SSP1” (Sustainability) indicates good progress towards sustainability, with sustained efforts to achieve development goals while reducing resource intensity and fossil fuel dependency. On the other hand, “SSP4” (Inequality) indicates a highly unequal world within and across countries, with most people vulnerable to climate change; while “SSP5” (conventional) indicates conventional development with domination of fossil fuels and high greenhouse gas emissions.
The scenarios produced by the IEA (World Energy Outlook and Energy Technology Perspectives scenario portfolios, including transition issues) and the WEC are today the most widely used by companies, though all suffer from methodological constraints and relative criticism. Public climate scenarios on which companies rely to conduct their analyses are indeed particularly complex to grasp, and have not initially been designed for use by companies (despite SSPs). Some of their limitations (lack of breakpoints; assumption of constant economic growth) also sometimes undermine their reliability when applied to specific business models and environments. Companies therefore need to find the right level of adequacy between their needs and existing transition scenarios.
They therefore aim to project the evolution of energy flows, GHG emissions and certain socio-economic variables into the future. Due to the fact that the transition trajectories and the impacts of climate change will jointly affect economic actors, the implementation of a low-carbon and climate-resilient trajectory requires identifying the interferences between the actions undertaken for the low-carbon transition and those undertaken to adapt to the impacts of climate change: this is why the IPCC has also been calling for the development of sustainable socio-economic trajectories, describing both a low-carbon and climate-resilient socio-economic trajectory (i.e. "integrated" scenarios, still at the emerging stage).
Extract from the IPCC’s Climate Change 2014 Fifth Assessment Report: the Representative Concentration Pathways are used for making projections and aim to describe four different 21st century pathways of GHG emissions and atmospheric concentrations, air pollutant emissions and land-use (figure A). Multiple lines of evidence indicate a consistent and almost linear relationship between cumulative CO2 emissions and projected global temperature change to the year (figure B).
In this context, scenario analysis is particularly beneficial in the context of companies' relations with their financial partners - first and foremost investors, who are exposed to the risks and opportunities arising from the low-carbon transition through the companies they finance, in terms of debt, equity and financial services. Rating agencies are also expected to use scenario analysis to assess the response of issuers - and governments - to climate change risks.
Source: TCFD, Final Recommendations Report, 2017 (p.8)
Conducting scenario analysis is a challenging exercise but remains an intermediate product in assessing a company’s resilience in the face of the low-carbon transition
Outside the energy sector (where companies consume large quantities of raw materials), the use of such innovative tools is particularly difficult – especially given that climate-related scenarios have not been initially designed to be used by companies. Therefore, companies still remain in the early stages of the process of using climate-related scenarios internally (TCFD, 2019; I4CE, 2019; EFRAG, 2020), and must continue evolving their approaches while learning how to integrate scenarios into corporate strategy formulation processes. Challenges are primarily methodological, given that companies currently lack relevant data and tools to support their analysis, and have difficulties linking scenarios to business needs.
Current deadlocks identified by Policy Shift relate to:
All in all there remain various the difficulties for understanding scenario analysis and its construction (i.e. diversity of input assumptions; scientific underpinnings; complex presentation of results); as well as limited data accessibility. Scenario analysis indeed requires the generation of a significant amount of information, some of which is potentially sensitive - thus raising the question of the choice of elements and their transmission channel to the external entity conducting the analysis.
Despite such difficulties, the scenario-based approach can remain flexible and given the low-carbon transition circumstances, there is a need to demystify scenario analysis in order for companies to enter into a truly forward-looking approach. It is therefore crucial not to directly conduct a necessarily holistic and quantitative exercise, but to set in motion a learning process in prospective analysis (based on the work of Mietzner and Reger (2005) on the architecture of prospective analysis by scenarios). In particular, the financial and business impacts related to climate change can therefore vary considerably depending on the industry and economic sector(s)/sub-sector(s) in which an organization operates. They can also vary significantly depending on the geographical location of the organization’s value chain (upstream and downstream); the organization’s assets and the nature of its operations; the structure and dynamics of the organization’s supply and demand markets; and its customers and other key stakeholders.
Two French think-tanks have developed guidelines in that regard, that are particularly useful to set up such a “learning process” for companies (Shift Project, 2019; I4CE, 2020). The European Commission has also insisted on scenario analysis as a tool for the company to describe its business model "in a way that clearly links its activities to climate change". More specifically, the Commission has underlined that:
"The climate-related risks and opportunities to which a company is exposed will depend on the nature of its business, its geographical location and its positioning in the transition to a low-carbon, climate-resilient economy. In order to properly integrate the potential effects of climate change into their planning processes, companies need to consider how climate risks and opportunities may evolve, as well as their potential business implications under different conditions. Scenario analysis is one way to assess these implications. Companies that do not sufficiently examine their business model and strategy in the light of climate change may cause negative climate impacts and may themselves be negatively impacted by climate change on their business, including their income statement, financing, future regulatory burden and "social license to operate". Furthermore, the identification of new climate-related opportunities can strengthen a company's business model and profit prospects".
A four-stage exercise could help to take into consideration the implications of the low-carbon transition on the company's activity, all by relying on available external resources, helping to initiate an iterative approach.
As regards stage 3, it should be noted that for this purpose, multiple methodological resources exist and shared exercises are possible (particularly when deciphering transition issues and mapping vulnerabilities upstream, which can be conducted at the level of a sector, for example). Companies can also rely on the methodologies developed by the "Science-Based Targets" initiative and by ADEME (the “Assessing Low-Carbon Transition” methodology).
Several steps forward can therefore be contemplated
Scenario-based analysis therefore stands as an intermediate product of a wider resilience-assessment approach. This approach is particularly useful to reinforce the company’s links with its financial partners and external stakeholders (including consumers and the civil society) as it exposes the company's ability to integrate prospective analysis into the implementation of strategic decisions.
Companies can therefore describe (i) their ability to integrate prospective analysis into their strategy, (i.e. description of the process put in place to assess the resilience of the business model to climate change mitigation and adaptation issues); (ii) the critical input parameters, assumptions and analytical choices made for the scenarios used; (iii) the resilience of the company's strategy, and in particular the key strategic implications identified for the organization's operating results and/or financial position and how it plans to adapt to the climate challenges (and their socio-economic consequences) identified.
Scenario analysis should also be seen as a component of corporate strategy. For instance, in its recommendations to the role of the board of directors in addressing climate change issues, the French Institute of Directors stressed that climate issues must be at the heart of the definition and implementation of corporate strategy, and that the board of directors plays a key role in ensuring that management takes the necessary steps to identify the risks and opportunities for the company's activities affected by climate change through forward-looking analysis.
It is therefore all the more important that stakeholders continue to develop scenarios applicable at 2°C (or below) at the sectoral level and according to geographical areas (in order to adapt better to the needs of companies). They should further develop and improve access to methodologies, databases and tools to enable organizations to more effectively conduct scenario-based transition and physical risk analyses at more granular sectoral, geographical and temporal levels; and to develop guidance for investors to better understand and use scenario information.
The example of Unilever
In their 2019 report, the multinational consumer goods company performed a scenario analysis assessment to fully understand the impact of climate change on their business in the future, under 2°C and 4°C global warming scenarios (by 2100), and by focusing on the year 2030.
According to their 2019 report, Unilever wanted to keep their scenario analysis as simple as possible, by considering only two scenarios and using simplifying assumptions. A small project team, led by the financial department, and with representatives from other functions (Research and Development, Procurement, Sustainable Sourcing and Commodities), was set up. The company also used the support of external third parties to provide expertise and knowledge in order to improve the quality of the analysis.
As reported, the company made two main assumptions:
In the 2°C scenario, Unilever assumed that in the period leading up to 2030, society would act rapidly to limit greenhouse gas emissions and puts in place measures to restrain deforestation and discourage emissions (for example, implementing carbon pricing at $75-$100 per ton, taken from the International Energy Agency’s 450 scenario). They assumed that there will be no significant impact to business from the physical ramifications of climate change by 2030 – . from greater scarcity of water or increased impact of severe weather events. The scenario assesses the impact on business from regulatory changes.
In the 4°C scenario, Unilever assumed climate policy is less ambitious and emissions remain high so the physical manifestations of climate change are increasingly apparent by 2030. This scenario focuses on risks resulting from the physical impacts of climate change.
Both internal and external data was needed, since external data was used to understand the climate related risks and opportunities. This was then mapped against internal business data to show the area of business impact. Surrogate or proxy data (e.g. carbon footprint data, commodity prices) and other assumptions were also used to fill data gaps. Data from the IEA’s World Energy Outlook and climate impacts associated with the IPCC’s RCP 8.5 was used, as well as 2015 forecast sales, greenhouse gas (GHG) emissions and tons of commodities.
The results showed that without action, both scenarios present financial risks to Unilever by 2030, predominantly due to increased costs. However, while there are financial risks which would need to be managed, the company would not have to materially change its business model. The most significant
impacts of both scenarios are on the supply chain where costs of raw materials and packaging rise, due to carbon pricing and rapid shifts to sustainable agriculture in a 2°C scenario and due to chronic water stress and extreme weather in a 4°C scenario. The impacts on sales and manufacturing operations are relatively small. Unilever has therefore developed and piloted an approach to assess the impact of climate change on key commodities, including soy and black tea.
This example shows that scenario-based analysis can turn into a true intermediate product of a wider resilience-assessment approach, while “demystifying” the difficulties associated with scenario analysis. It highlights the fact that a company - including one as wide as Unilever - can develop a strategic response as well as a specific action plan and monitoring system, as a result of scenario analysis.
Some external sources and extra information
On migration and climate change
IOM, The social dimensions of climate change, 2011. Available online: https://www.iom.int/jahia/webdav/shared/shared/mainsite/activities/env_degradation/cop17/SDCC-Social-dimensions-of-climate-change-Paper.pdf
On physical and transition risks
Transitioning to a lower-carbon economy may entail extensive policy, legal, technology, and market changes to address mitigation and adaptation requirements related to climate change. Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to organizations (TCFD, 2017).Physical risks resulting from climate change can be event driven (acute) or longer-term shifts (chronic) in climate patterns. Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations’ financial performance may also be affected by changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting organizations’ premises, operations, supply chain, transport needs, and employee safety (TCFD, 2017).
On planetary boundaries and the Anthropocene These issues are also associated with the consideration of global limits (Rockström et al. 2009) and the problems inherent to the Anthropocene (Crutzen, McNeill and Steffen, 2007). See Policy Shift article here.
On uncertainties related to climate change
As illustrated by recent work of the IPCC (IPCC, 2018). These uncertainties relate in particular to the location, frequency and magnitude of changes, making it more difficult to predict physical risks in particular (Hallegate, 2008), but also their socio-economic consequences (OECD, 2015). They are exacerbated by uncertainties relating to the geopolitical and commercial environment in which firms operate, making the business environment unstable throughout the value chain (the physical determinants of firms' activity will be structurally affected by changes in the energy production and consumption system).
On socio-economic consequences of the low-carbon transition
Taking into account the organizational dependencies and the social consequences that result. Beyond the price of carbon (and associated mechanisms such as taxation or the carbon trading market), these changes will materialize, for example, through new norms and standards and the granting of subsidies for the deployment of infrastructure or low-carbon technologies. These transformations will also lead to cascading changes in the economy (I4CE, 2020), via value chains, across all sectors (see: https://www.sciencedirect.com/science/article/pii/S0306261920303603).
See IPCC, 2015, Economic and Social Dimensions of Climate Change; Richard S.J Tol, 1998, Estimating socio-economic impacts of climate change) : Climate migration (IOM, 2008; Podesta, 2019).
On the influence on corporate profitability
Such influence is all the more important considering the changes in demand (i.e. reputational issues; consumer preferences; emergence of new technologies; standards in favor of low-carbon products), changes in the costs borne by companies (in terms of energy and raw materials, in particular), and the value of assets in a transition economy.
On the role of prospective analysis
A "strategic foresight approach" as in Godet and Durance, 2011: an anticipation in order to illuminate the present action in the light of possible and desirable futures
It should be noted that scenario analysis by companies dates back to the 1970s, in a context of geopolitical tensions, with early examples of use by companies in the oil and gas sector, such as Royal Dutch Shell (Schoemaker and Cornelius, Integrating scenarios into strategic planning at Royal Dutch Shell, 1992), although analysis for resilience in the low-carbon context is more recent (early examples date from 2015 and 2016, respectively by BHP Billiton and Glencore). It should be noted that in France, as the Shift Project points out in its report for Afep (November 2019), there has historically been a "culture of foresight", under the influence of the Commissariat Général au Plan and then France Stratégie and following the example of the work carried out by Futuribles.
See: Zenghelis, Dimitri and Stern, Nicholas. The importance of looking forward to manage risks: submission to the Task Force on Climate-Related Financial Disclosures. Policy Paper, June 2016.
On climate scenarios
It should be noted that criticisms have arisen following the observation that most scenario users rely mainly on the scenarios designed by the IEA (given its anteriority in the design of scenarios; its recognized energy expertise; and its significant resources) - notably because of a low ambition in terms of reducing the use of fossil fuels. Also, for many scenarios, criticism has emerged on the absence of the notion of "rupture" in the input hypotheses; the fact that the population criterion is often exogenous and does not take into account the physical impacts of climate change; that GDP is rarely affected by the consequences of climate change; and finally, the fact that the control of the rebound effect is not taken into account.
Some socio-economic variables into the future are considered structuring factors in the evolution of CO2 emissions under the Kaya equation: quantity of energy produced, CO2 content of energy produced, GDP growth, energy intensity of GDP, and population size. Generally, a scenario is part of a "scenario family", which includes a reference scenario, not constrained by the achievement of a climate objective (using "Shared Socio-economic Pathways") and the scenarios compared to them (including a climate objective to be achieved) - each family of scenarios aims to respond to a given problem, explained in a "narrative", consisting schematically of varying the determinants of the Kaya equation. Other elements are also considered, such as the deployment of carbon capture and storage technologies (CCS/CCU) making it possible to accompany the reduction of CO2 emissions (the pace and extent of which differ according to the scenarios), data on the availability of transition materials, in particular rare earths and metals (Hache, 2019; Ademe, 2017), and the challenges of adaptation to climate change, in particular with regard to the physical consequences of climate change (IPCC, 2018; Xu, Kohler, Lenton et al. , 2020). Finally, some variables are exogenous (input data from external sources, e.g. GDP, cost of technologies) while others are endogenous (resolved by the model, e.g. amount of energy produced).
See: Annex 1 of the Technical Annex on Scenario Analysis of the TCFD (2017); Shift Project & Afep, "Energy-Climate Scenarios", Nov. 2019; Santoso H., Idinoba M., Imbach P., Climate Scenarios, 2008; IPCC, Climate Scenario Development, 2018; US Global Research Program, Climate Science Special Report (Chapter 4), 2017; Colin, Vailles and Hubert, Understanding Transition Scenarios, 2019.
On the role of rating agencies
See: Moody’s Investor Services, ESG – Global: Climate scenarios vital to assess credit impact of carbon transition, physical risks, mars 2020. Available online: https://www.moodys.com/research/Moodys-Scenario-analysis-key-tool-in-assessing-credit-impact-of--PBC_1217369
On the current use of scenarios by companies
See: I4CE, Very few companies make good use of scenarios to anticipate their climate-constrained future, February 2019. The study revealed that out of 2000 companies responding to the CDP's climate change questionnaire, only 5% were using scenario analysis to study the resilience of their business model to climate and energy issues (of which more than half were from the energy sector and based in the European Union).