Scenario models have formed a substantive part of managing financial risk for years. Climate impacts – and transition - bring new subtleties to the way organizations and governments understand and use them.
Climate scenarios are descriptions of plausible future climate conditions and are used to understand a potential range of future climate change and its impacts, as well as to identify opportunities for climate mitigation and adaptation.
Scenarios have been used for planning purposes for decades. As computational power has grown, the ability to build complex scenarios has grown with it, alongside the power to test assumptions, conduct sensitivity analysis and solve complex optimization problems. The oil price shocks of the 1970s accelerated the use of planning tools to maintain short-term financial stability and manage long-term energy system transitions – this was also one of the driving forces for the creation of the International Energy Agency, whose scenarios are widely used today to understand how the world might decarbonize.
Climate scenarios are used to understand a potential range of future climate change impacts and identify opportunities for climate mitigation and adaptation.
How scenarios are built
Scenarios can be exploratory or normative. Exploratory scenarios build a wide range of possible future emissions scenarios to explore the consequences of these different pathways. They are not predictions, but rather their wide range helps develop an understanding of plausible outcomes for decision-making. Normative scenarios, on the other hand, describe a pre-specified future that can be achieved with only a specific set of actions. These scenarios can be used to explore the potential consequences of meeting a specific emissions reduction target – particularly the technology and policy options needed to get us there.
The process of developing these scenarios starts with making assumptions about population growth, economic growth, land use changes, and energy consumption in the future. These assumptions feed into models of society and economy called integrated assessment models (IAMs) that output emissions scenarios or trajectories of future GHG emissions – these are exploratory scenarios when the emissions profile is an output, and normative scenarios when the emissions profile is a target. Subsequently, the emissions scenarios determine the future radiative forcing (i.e., net energy gain by the Earth's atmosphere), which is a key input for projecting the future climate.
The scale of assumptions, the lack of quality baseline data for most of the world, and the uncertainty of the linkages between socio-economic factors and the earth system impacts every modelling effort, producing results which may not be completely representative of the future it is trying to analyze. For instance, estimating temperature changes as per carbon budgets is probabilistic in nature. The Intergovernmental Panel on Climate Change (IPCC) estimates that there is 67% chance of staying below 1.5°C if 320 Gt of carbon dioxide is emitted from 2022. This probability reduces to 50% if 420 Gt are emitted instead. Communicating the assumptions and level of uncertainty associated with scenarios is increasingly important to ensure disclosures by financial institutions and businesses are not misinformed and risk management approaches by these entities and government are calibrated to the uncertainty.
Climate scenario applications
Climate scenarios can be used by financial institutions, businesses, and governments for various purposes:
- Scenarios can help understand potential changes in hazards or extreme weather in different regions and sectors and subsequently develop adaptation strategies to the impacts of climate change.
- Scenarios can be used for short- and long-term planning to understand and quantify the benefits of risk mitigation actions as compared to the future cost of responding to the risk.
- Scenarios can contribute to understanding the trade-offs and quantify the costs associated with different potential climate mitigation strategies, compared to the quantifiable benefits of reduced damages from the physical effects of climate change.
Transition risk refers to the risks and opportunities from a transition to a low-carbon economy and brings additional subtleties to climate scenario modeling. Under a transition compliant with the Paris Agreement, most sectors of the economy, such as energy generation or transportation, will see dramatic changes to the demand for energy fuels alongside a switch from carbon-intensive to decarbonized technologies. Markets may or may not be currently fully pricing in this shift, which will have a large long-term impact on a public or private entity, particularly in certain sectors like oil and gas exploration. These impacts can be quantified by modeling the entity's future cash flows, taking into account the changing revenues and costs due to the low-carbon transition. WTW's Climate Transition Analytics team quantifies the difference in discounted future cash flows between a business-as-usual and a climate transition scenario as the Climate Transition Value-at-Risk (CTVaR).
Climate scenarios form the foundation of how we quantify CTVaR – the mismatch between what is priced into the market today, and where risks and opportunities lie in a low-carbon world. Our business-as-usual scenario represents a world where policy ambition is limited to existing commitments - which are inadequate to meet 1.5°C, or even 2°C temperature targets. Meanwhile, our climate transition scenarios imagine a world where we meet temperature targets through a combination of effective climate policies, technology improvements and behavioral change. In this world, the demand for fossil fuels drops significantly, while there is a massive increase in renewables penetration, even more than what is currently priced into the business-as-usual scenario.
Moreover, as the world transitions to a decarbonized energy system, our business-as-usual scenario must keep up – for example, we consider that the growth in electric vehicles (EVs) needed in a 2°C world is already aligned with the EV production plans for major carmakers, which means that we would consider the 'CTVaR' for electric vehicles to be zero. For most sectors of the economy, however, there is still a mismatch between where the markets currently are and where they need to be for the world to stay within safe climate thresholds. Figure 1 illustrates our view on a 1.5°C compliant transition in passenger transport – the numbers are based on our own sectoral decarbonisation models.
Transition risk refers to the risks and opportunities from a transition to a low-carbon economy.
Moreover, as the world transitions to a decarbonized energy system, our business-as-usual scenario must keep up – for example, we consider that the growth in electric vehicles (EVs) needed in a 2°C world is already aligned with the EV production plans for major carmakers, which means that we would consider the 'CTVaR' for electric vehicles to be zero. For most sectors of the economy, however, there is still a mismatch between where the markets currently are and where they need to be for the world to stay within safe climate thresholds. Figure 1 illustrates our view on a 1.5°C compliant transition in passenger transport – the numbers are based on our own sectoral decarbonisation models,
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