Time for strategic climate scenario analysis
Do you know what you’re going to insure in a 3-degree world? How will the profitability of products and services change under different climate scenarios? Are you pricing for the disruption of supply chains within your business interruption or credit insurance products?
Climate change raises complex questions, and Climate Scenario Analysis (CSA) is a vital tool to help businesses adapt and prepare.
With current governmental strategies, global temperatures are projected to rise by 3.1°C this century, far beyond the 1.5°C Paris Agreement target. This means an unprecedented increase in the intensity and frequency of physical risks, as well as unpredictable trends in transition risks: historical data is no longer a suitable basis for business decisions. This presents an opportunity to strategically use CSA to inform business strategy, informing decisions through analysis of potential futures.
Enhancing CSA capabilities is increasingly a key focus for financial institutions and regulators. However, there is not a ‘one size fits all’ analysis, but a range of potential scenarios with different purposes. The value lies in selecting the right scenarios for the right purpose. You don’t need to create new scenarios - there are plenty of science-based ones available, but what matters is aligning your scenario selection with your strategic objectives.
Setting your CSA Strategy
CSA should begin with clear objectives, agreed upon at board-level. Firms must document the rationale behind scenario selection and demonstrate how the results inform decision-making. When setting the objectives, you can use your double materiality analysis and climate risk register to inform the process.
Firms should ask themselves a few important questions in this process.
- To give confidence that business plans are robust and business models are secure.
- To inform operational resilience strategy.
- To support climate risk identification.
- To analyse material climate risks.
- Will certain business lines remain profitable over the next decade? How will insured losses evolve?
- How will the transition to net zero impact our key sectors, and what implications does this have for our business lines?
- How should potential ‘inflexion points’ be considered when everything changes, and what early warning signals might be available to firms to identify the right time to act on prepared plans?
- How will climate risk influence premium pricing, and what effects might these pricing changes have on the overall business?
- To what extent might climate-related physical risks increase operational risks, including risks to own assets (e.g., data centres) or key third parties?
Selecting tools and frameworks
Once the purpose of your CSA is clear, the next step is selecting the appropriate model and scenario(s). All models are built on assumptions - these are not flaws, but features that must be understood and accounted for. Rather than shying away from them, firms should embrace transparency around assumptions and ensure they are factored into decision-making. If key variables or conditions change, the analysis should be revisited and updated accordingly.
A useful framework for scenario selection is the Intergovernmental Panel on Climate Change’s (IPCC) Shared Socioeconomic Pathways (SSPs). These scenarios combine different trajectories of socioeconomic development (e.g., inequality, fossil-fuel reliance) with climate outcomes, such as the greenhouse gas concentration trajectories Representative Concentration Pathways (RCPS). For example, SSP2-4.5 represents a ‘middle-of-the-road’ scenario with moderate mitigation, while SSP5-8.5 reflects a high-emissions, fossil-fuel dependent pathway.
Market criticism
Insurance organisations are used to dealing with uncertainty – if a risk were certain to occur, there would be no profit or product. However, some voices are saying that CSA is not accurate enough to be useful. Even the best scenario analysis models are based on numerous assumptions and often haven’t yet incorporated the ‘latest science’, which is evolving rapidly.
Potential assumptions that are often overlooked or difficult to incorporate into models include various factors.
- The interaction between risks (e.g., physical risk interacts with transition risk, such as a large natural catastrophe potentially influencing policy and market dynamics).
- Global tipping points.
- Impacts of nature and biodiversity, including our ocean (e.g., ocean acidification).
- Waste management and its environmental implications.
Our response? This is why having a clear CSA strategy is so important – the selected scenarios should be tailored to the specific questions you're trying to answer. While all models involve assumptions and uncertainties, these should not deter analysis. Instead, they must be acknowledged, documented, and revisited as conditions evolve. Applying a generic 2°C warming scenario across all analyses is unlikely to yield meaningful insights. In many cases, it is more appropriate to explore a broader range of futures, including more extreme warming pathways, to fully understand potential exposures and vulnerabilities.
At the end of the day, having a CSA tailored to your business is better than the alternatives – guessing or worse, hoping the problem will go away.
What actions should be taken today?
- Boards should own the process and understand the inputs, assumptions, model capabilities, and limitations.
- It’s a team effort - a range of CSA scenarios will need a broad set of expertise from across the organisation to address topics such as coastal flooding, litigation risk, or supply chain exposure.
- CSAs have several purposes, and multiple analyses will likely be run. Setting a clear purpose for CSAs is an important foundation for everything else.
- Firms should tailor CSAs to the material risks and opportunities they face. This means going beyond the obvious natural catastrophe risks; CSAs should also address other critical exposures, such as liability, regulatory, and policy risks.
- CSA is not a ‘standalone’ activity, but one that should be integrated throughout the business, particularly within business planning and capital setting.
- This means going beyond insurance risk; you need to consider impacts on reputation as well as operational resilience, including third-party risk management.
Elevating CSA from compliance to strategy
CSA provides an opportunity for firms to use future-looking analysis to inform their business strategy. However, it must be done right. Despite being a regulatory requirement in many jurisdictions, CSA is too important to address as simply a compliance exercise, it is a strategic tool that brings insights. Organisations should take the opportunity to review their CSA strategy and the purpose of the CSA. In this way, firms can maximise the benefit of CSA and utilise the results in a meaningful way.
Through our practical and experienced team, our Consulting team continues to support our clients in setting their own agenda to address rapidly changing sustainability and climate-related requirements.
Please contact Alex Hindson or your usual Crowe contact for more information.
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