In the second and final part of their article on climate-related risk, Dr Glenn Frommer and Theodora Thunder, Principals, The Sustainability Partnership, introduce and examine the role and value of scenario analysis in identifying, assessing and quantifying the risks of climate-related impacts.
The disclosure of an organisation’s forward-looking assessments of climate-related issues is of growing importance for investors and other stakeholders to understand how vulnerable the individual organisation is to climate issue risks, and how such vulnerabilities are or would be addressed. The consequences to the bottom line are increasingly hard to ignore. The Task Force on Climate-related Financial Disclosures believes that scenario analysis provides a powerful and viable tool for companies to assess the potential business, strategic and financial implications of the risks and opportunities and to disclose them, as appropriate, in their financial reporting.
Why scenario analysis?
Scenario analysis is a well-established analytical methodology that helps to look at alternative future possibilities and to reflect on the plausibility of outcomes and the implications. It puts decision makers in a position to be proactive versus reactive to events that matter in the future of their organisations. However, scenarios do not predict the future nor are they a product, but rather are processes to map a more sustainable future. They are challenging to undertake but prove useful in illuminating the drivers of change. For example, global warming impact on business continuity is now a substantial component within risk portfolios, but with an uncertain trajectory of impacts and timing. By using scenario analysis to address the uncertainty, companies can estimate the range of consequences by looking at the possibilities of global warming moving above or below the 2°C target set by the Paris Agreement as a basis for their risk assessment. By conducting analysis in this way, managers can achieve better appreciation of ‘unquantifiable’ risks when planning strategy. This is akin to ‘looking into the crystal ball’ or, in the words of former US Defence Secretary Donald Rumsfeld, working with ‘known knowns’, ‘known unknowns’ and, the worst case scenario, the ‘unknown unknowns’.
Scenario analysis can help organisations:
- consider issues, such as climate change, which have possible outcomes that are highly uncertain
- enhance the strategic conversation about the future by considering, in a more structured manner, scenarios that are different from business-as-usual
- frame and assess the potential range of plausible business, strategic and financial impacts from climate change and the associated management actions that may need to be considered, and
- identify markers that monitor the external environment and recognise when the environment is moving toward a different scenario state or a different stage along a scenario trajectory to prepare a robust business response.
Scenario analysis can also help investors in understanding the robustness of organisational strategies and financial plans and in comparing risks and opportunities across organisations.
Exposure to physical risks
While scenario analysis can be used to look at the future possibilities for both transitional and physical risks, the latter is currently more relevant to Hong Kong companies. Physical risks can be either acute or chronic. The former are short term and event driven, such as storm surges and extreme heat waves, whereas the latter are the effects of longer term shifts in climate patterns, such as sea level rises, drought or rising air temperatures.
Conducting physical risk scenarios are particularly relevant for organisations with long-lived and fixed assets; locations or operations in climate-sensitive regions such as coastal and flood zones; reliance on the availability of water; and/or having their value chains exposed to these situations or circumstances. Such risks in some way affect most Hong Kong industries and companies either directly or through their supply chain.
Physical risk scenarios generally identify extreme weather threats of moderate or higher risk and typically focus on the consequences over shorter time frames, such as the life cycle of their respective assets or liabilities. These can vary across sectors and organisations. For example, flooding and intense storm surges in Hong Kong have a history of damaging buildings and infrastructure and disrupting operations, transport, city services and business continuity. The unknown risk factors linked to climate change are the intensity and frequency of such events. Atlantic hurricanes Sandy, Harvey, Irma and Maria are examples of the damage that is increasingly likely as storm intensity and frequency increases. Impacts of such magnitude are now firmly on exposed cities and corporate risk radars as far more likely to occur as global warming continues on its current trajectory.
Scenario building blocks
Conducting useful scenario analysis starts with asking the right questions around the identified risk. For example, are questions rooted in the future, not the past? What are the core drivers of each scenario? Often three to four scenarios are constructed, which propose outcomes ranging from business as usual to more severe risk developments. An impact-uncertainty matrix is helpful in mapping the forces that are most relevant across the different scenarios. Scenario narratives are then developed and internally assessed. Important to the process of building and narrating scenarios is the development of monitorable progress indicators linked to each scenario. These can include both fixed markers, for example a monetary value exceeded, and overall trends such as global warming exceeding the 2°C threshold under the Paris Agreement. Observing these can indicate the particular scenario’s trajectory and alert management to changes in the risk strategy programme.
With these developed scenarios, management can disclose with some degree of confidence how resilient, qualitatively or directionally, the organisation’s strategy and financial plans may be against the range of impacts due to climate change related issues. Disclosure of this type of information helps investors, the financial community and other stakeholders understand the robustness of an organisation’s forward-looking strategy and financial plans across a range of possible future scenarios. Such a narrative also enhances the internal understanding of operating in environments in which long-term thinking, flexibility and contingency planning are necessary. Presented with a range of possible future trajectories, management decisions are better informed.
Learning from others
While this article does not explore the ‘how to’ of scenario analysis, we refer readers to the actual process and value of scenario analysis in a relevant example for Hong Kong, illustrated in the recent Union of Concerned Scientists’ report, Underwater: Rising Seas, Chronic Floods, and the Implications for US Coastal Real Estate (www.ucsusa.org). This scenario analysis study estimates the risks for US coastal real estate from sea level rise, and the challenges and choices communities and owners face now and in the decades to come. The study employs three scenarios – high, medium and low rises – to assess the growing risks and consequences to property owners, developers, financiers, communities and the economy from the disruptive flooding of the coastal real estate sectors due to sea level rise. The outcomes, even with best-case scenario, cite USD billions in asset value lost, unaffordable mortgages and even denial of insurance coverage, as well as outright loss of an asset. This is a chronic physical risk study that has parallel implications and warnings for Hong Kong’s own waterfront properties.
Properly used, scenario analysis can be a powerful tool for managing strategy in an uncertain environment and supporting more thoughtful and proactive business decisions. It brings insight to the potential futures in which an intervention will operate, what a company will need to do to succeed in each future and what needs to be done to make that success possible. Scenario analysis is about the decisions made today that create the company of tomorrow. By addressing rather than minimising uncertainty, businesses can choose and direct a more sustainable pathway for their development.
Dr Glenn Frommer and Theodora Thunder, Principals
The Sustainability Partnership
The Sustainability Partnership advises companies on the end-to-end management of environmental, social and governance issues and their reporting.
For further information contact: Thunder@streeter.com.hk.