Climate Scenario Analysis: A Hot New Tool for Financial Institutions

Executive Summary

Scenario analysis has long been used by a variety of actors to better assess how certain events might affect their operations and finances. Recently, a growing concern for climate change has birthed demand for scenario analysis tools to help financial institutions, corporates, and regulators prepare for climate eventualities, known as “climate scenario analysis”.

The recommendations published in 2017 by the Task Force on Climate-related Financial Disclosure (TCFD) have undoubtedly propelled this trend. The initiative, created in 2015 with the objective to improve and standardize companies’ climate-related disclosures, has gained increasing support over time, becoming a global standard. Among its key guidelines, the TCFD recommends the use of climate scenario analysis as a forward-looking solution which allows entities to better understand the impacts of climate change.

Just after the release of the TCFD guidelines, eight central banks joined together to form the Network for Greening the Financial System (NGFS), with the objective of improving environmental and climate risk management in the financial sector. Today, the network counts over 100 members. It has also advocated for the use of climate scenario analysis as part of central bank stress testing exercises.

Regulatory changes and voluntary initiatives have led to the emergence of climate risk solutions. Vendors include providers who already inhabit the environmental, social, and governance (ESG) data universe (e.g., ISS ESG), as well as credit rating agencies (e.g., Fitch, Moody’s, and S&P), insurance software vendors (e.g., Verisk), and consultancies (e.g. Baringa, Oliver Wyman, and PwC). Though most climate risk solutions are new, many of their components have been built off of the existing technologies and processes of the aforementioned providers.

Comprehensive climate scenario analysis is a process that requires a wide range of financial and climate expertise. As such, most solution providers have turned to partnerships and acquisitions to build out their tool sets.

The use of climate scenario analysis is relatively new, and some use cases, such as the pilot exercises being conducted by many central banks, are still experimental. While the market for climate scenario analysis tools and advisory remains small, Opimas believes that it could grow meaningfully in the coming years.

This would certainly be the case if regulatory bodies decide to increase the costs associated with financial activities linked to climate risk. To that extent, the ongoing debate on increasing capital requirements imposed under Pillar 1 of Basel regulation for banks with significant exposure to climate risk is something to watch carefully.

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