Climate-Related Financial Disclosures (TCFD): Scenario Analysis and Climate-Related Issues
Scenario Analysis and Climate-Related Issues aim to incorporate the development and potential impacts of climate-related risks and opportunities under different conditions into organizational decision-making plans, helping organizations understand their performance under various future scenarios. In other words, organizations facing climate-related risks should consider using scenario analysis to support decision-making and financial planning, and disclose their adaptability to various potential climate scenarios to the extent possible.
According to the "Recommendations of the Task Force on Climate-related Financial Disclosures," this section can be divided into four components:
1. Overview of Scenario Analysis: Assuming a potential future climate scenario within a limited scope, identifying and assessing its potential impacts on business, strategy, and financial performance, using quantitative or qualitative analysis.
2. Climate-Related Risk Exposure: Climate change affects different industries and organizations differently. Companies more affected by transition risks (such as petrochemical and energy-intensive industries) or organizations more affected by physical risks (such as agriculture, transportation, construction, tourism, and insurance) should consider conducting scenario analysis.
3. Recommended Approaches
- Select reasonable future scenarios covering various advantages and disadvantages, such as global average temperature rise of 2°C or more severe climate conditions, and other factors like Nationally Determined Contributions (NDCs), physical climate scenarios, or other challenging scenarios.
- Conduct multiple scenario analyses, assuming at least 2-3 future scenarios.
- Organizations more affected by transition or physical risks should conduct rigorous qualitative and quantitative analysis of key factors and trends affecting operations, disclosing important assumptions and management pathways related to scenarios; organizations less affected by climate issues should still consider whether their organizational strategy and financial planning are resilient to climate change scenarios to maintain forward-looking strategies and sound financial plans.
4. When conducting scenario analysis, strive to achieve
- Transparency of parameters, assumptions, analytical methods, and timelines
- Comparability of results across different scenarios and analytical methods
- Complete documentation of methodology, relevant assumptions, data sources, and analysis
- Consistency of methodology used each year
- Effective management of relevant implementation, verification, approval, and application
- Effective disclosure of various possible climate scenarios to facilitate constructive dialogue between investors and organizations on potential impact scope and organizational strategy resilience
What are the benefits of conducting scenario analysis?
- Better understand how the company will perform under different future scenarios and whether it has sufficient adaptability or robustness to face climate risks.
- Under climate change conditions, assuming climate-related scenarios helps companies develop and explore how physical risks, transition risks, or opportunities from climate change will affect business over time.
- Simulate various possible future scenarios through different assumptions and parameter conditions to help companies predict various possible outcomes under different future scenarios.
How to choose appropriate future scenarios?
Common climate scenarios mainly fall into two types: "transition scenarios" represented by the International Energy Agency (IEA) and "physical climate scenarios" represented by the Intergovernmental Panel on Climate Change (IPCC). Additionally, there are the "Science Based Targets initiative," "Nationally Determined Contributions," and the "Shared Socioeconomic Pathways" used in IPCC AR6 to estimate future emission scenarios. Here's an introduction to each:
1. Transition Scenarios: Assuming effective climate strategies and climate-friendly technologies will help limit greenhouse gas emissions, using simulations to illustrate how energy supply and demand policies and technologies interact with economic activity, energy consumption, GDP, and other key factors. These scenarios will have significant short, medium, and long-term impacts on organizations in specific economic sectors. The IEA proposed four scenarios in "World Energy Outlook 2021":
(1) Net Zero Emissions by 2050 Scenario (NZE): Global energy sector achieves net zero emissions by 2050, with advanced economies reaching net zero earlier than others, limiting global temperature rise to 1.5°C
(2) Sustainable Development Scenario (SDS): Based on significant increases in clean energy policies and investment, global temperature rise stays well below 2°C by 2100, achieving Paris Agreement goals
(3) Announced Pledges Scenario (APS): Commitment to emission reduction efforts to achieve net zero by 2050, including national targets from 2030 to 2050. By 2100, global average temperature approximately 2.1°C higher than pre-industrial levels
(4) Stated Policies Scenario (STEPS): Does not assume all announced goals will be achieved, taking a more conservative approach. By 2100, global warming at least 2.6°C
2. Physical Climate Scenarios: Assuming different ranges of atmospheric greenhouse gas concentrations and explaining possible temperature ranges. Usually presented using results from global climate models showing Earth's climate response to changes in atmospheric greenhouse gas concentrations. The IPCC uses "Representative Concentration Pathways (RCP)" (pathways referring to concentration change trajectories) to estimate different degrees of global warming scenarios, including four pathways:
(1) RCP8.5: High emission scenario, meaning business as usual (BAU), emissions continue to rise, by 2100, global temperature rise approaches 4°C
(2) RCP6.0: Medium-high emission scenario, emissions rise until 2080 then decline, by 2100, temperature rise may exceed 2°C
(3) RCP4.5: Medium emission scenario, by 2080 emissions reduced to half of current levels, by 2100 temperature rise likely not to exceed 2°C
(4) RCP2.6: Low emission scenario, by 2050 emissions halved, temperature rise not exceeding 2°C, potentially achieving Paris Agreement 2°C or 1.5°C goals
▴ RCP four pathways - which path will you choose?
Image source: The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities, TCFD (June 2017)
We recommend considering both ideal and less ideal climate scenarios. Therefore, you can choose climate scenarios consistent with the Paris Agreement goal of limiting global warming to 2°C or the more ambitious 1.5°C as the target for corporate analysis. For example, what transition risks will companies face to achieve the best climate scenario goals? At the same time, what physical risks will companies face if global warming exceeds 2°C or even 4°C? Below we use E.SUN Financial Holding's "2019 CSR Report" and "2020 Sustainability Report" as examples.
▾ E.SUN Financial Holding "2020 Sustainability Report" scenario analysis for "Transition Risk Impact Assessment" and "Physical Risk Assessment"
How to get started? Six steps for conducting scenario analysis
According to the "Practical guide for Scenario Analysis in line with the TCFD recommendations 3rd edition," there are six steps for conducting scenario analysis:
1. Management and Stakeholder Engagement
(1) Help management understand the importance of scenario analysis
(2) Establish a team to conduct scenario analysis
(3) Establish analysis objectives
(4) Determine the time horizon
2. Assess Materiality of Climate-Related Risks
(1) List climate-related risk items
(2) Identify potential business impacts of risks
(3) Assess materiality of climate-related risks
3. Identify and Define Scenario Scope
(1) Select appropriate scenarios: such as future scenarios provided by IEA or IPCC
(2) Select parameters related to risks or opportunities as forecast information: such as disasters, fossil fuel prices, electricity prices, carbon prices, carbon taxes, renewable energy development costs, policies and regulations, etc.
(3) Shape worldview (future scenarios) from the perspective of the company and stakeholders
4. Assess Business Impacts
(1) Identify potential financial indicators affected by risks and opportunities
(2) Select calculation formulas and estimate financial impacts
(3) Note the gap between future outlook and business-as-usual (BAU) financial indicators
5. Identify Potential Response Measures
(1) Understand the company's current status in potential risk management and opportunity capture
(2) Consider strategies for climate-related risk management and opportunity capture
(3) Establish practical action plans and organizational structure
6. Documentation and Disclosure
(1) Describe the relationship between TCFD recommended disclosures and scenario analysis
(2) Describe results obtained from each step
Image source: Practical guide for Scenario Analysis in line with the TCFD recommendations 3rd edition, Ministry of the Environment, Government of Japan Climate Change Policy Division (March 2021)
Next, please refer to the figure below. We use First Financial Holding's "2020 Sustainability Report" to demonstrate scenario analysis and financial impact in practice. In this section, they first assumed two climate scenarios and risks, and explained the analytical methods and results for assessing the financial impact of relevant risks on the company.
Scenario 1:
Scenario 2:
Above, we have outlined several key points you need to pay attention to in scenario analysis, such as how to select scenarios, how to assume scenarios and conduct analysis, etc. This section is considerably more complex than others and requires some time to digest. But I believe those who have patiently read this far have gained much, and congratulations on completing the entire TCFD process. Let's briefly review several key points you need to understand when implementing TCFD: besides the "Four Core Elements," there are also "Climate-Related Risks," "Climate-Related Opportunities," "Financial Impacts," and the "Scenario Analysis and Climate-Related Issues" introduced in this article.
If this is your first time implementing the TCFD framework, we recommend referring to sustainability reports produced by companies that have already implemented TCFD.
References:
E.SUN Financial Holding "2019 CSR Report" and "2020 Sustainability Report": https://www.esunfhc.com/zh-tw/esg/overview/download
First Financial Holding "2020 Sustainability Report": https://csr.firstholding.com.tw/tc/csr_report.html
"Practical guide for Scenario Analysis in line with the TCFD recommendations 3rd edition"
The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities, TCFD (June 2017)