Scenario analysis of transition risk in finance – Towards strategic integration of deep uncertainty

8 June 2022 - Climate Report - By : Romain HUBERT / Rachel Paya / Anuschka HILKE / Michel CARDONA

The restructuring of the economy towards a low-carbon system will lead to develop activities that are aligned with the needs of a net zero economy, to restructure others in order to make them compatible with these needs and to stop harmful activities. The financial sector needs to anticipate these dynamics to address strategic risks and seize opportunities for their financial service business. However, financial actors are not inherently equipped to factor in this transition risk characterized by the complexity and multiplicity of potential transition pathway, as well as the impossibility to define an objective probability distribution of future outcomes. This characteristic of transition risk is called “deep uncertainty”.

 

The need to clarify how financial actors should use scenario analysis for a strategic integration of deep uncertainty

As recommended by the TCFD, scenario analysis can be particularly useful to ensure proper strategic integration of the deep uncertainty around the low-carbon transition. Mainly through disclosure requirements, regulators have invited financial actors to implement the scenario analysis process and to account for its strategic consequences.

 

However, financial actors have disclosed patchy information on scenario analysis and its strategic use so far. They have often relied on third-party methodologies that can lack transparency and that face a range of common challenges.

 

While financial actors and regulators are gaining experience with scenario analysis, they may face difficulties identifying what should be done to ensure the strategic relevance of the exercise – including the appropriate integration of deep uncertainty.

 

A report defining good principles of scenario analysis for a strategic integration of deep uncertainty

I4CE has defined a range of theoretical good principles that should be implemented. They were defined based on: the review of analytical frameworks used by a range of service providers; insights from strategic foresight approaches applied in industrial contexts; research on decision-making under deep uncertainty.

 

As illustrated below, the principles are categorized according to six building blocks focusing on major aspects of a scenario analysis process that are necessary for a strategic integration of deep uncertainty. They are neither exhaustive nor representative of the chronological order of the steps of the process in practice.

 

The full report summarizes the principles as a checklist (see the short version in the executive summary and the complete version in the core report). The checklist covers not only technical aspects, but also organizational aspects to ensure the appropriate mobilization of the teams.

 

The checklist can be used for instance by financial actors to improve their internal approach and challenge their service providers, and by financial regulators and supervisors to clarify their expectations, through disclosure requirements and the review of internal risk management practices.

 

 

Click on this button to see the image

 

 

Several stakeholders should be mobilized to foster the effective implementation of the good principles

The methodological approaches to scenario analysis in finance comprise emerging relevant practices. However, as illustrated below, they also face several common challenges. The full report makes recommendations to address these challenges and stimulate the generalization of already relevant practices. While financial regulators and supervisors should guide scenario analysis implementation, a broader range of stakeholders should also collaborate to address the needs.

 

 

Click on this button to see the image

 

 

This report is part of the Finance ClimAct project and was produced with the contribution of the European Union LIFE programme. This work reflects only the views of I4CE – Institute for Climate Economics. Other members of the Finance ClimAct Consortium and the European Commission are not responsible for any use that may be made of the information it contains.

 

 

   

 

 

 

With the contribution of the European Union LIFE programme

Scenario analysis of transition risk in finance – Towards strategic integration of deep uncertainty Download
I4CE Contacts
Romain HUBERT
Romain HUBERT
Research Fellow – Climate risks, Adaptation and financial institutions Email
Anuschka HILKE
Anuschka HILKE
Finance Programme director – Financial regulation, Development finance Email
Michel CARDONA
Michel CARDONA
Senior associate Expert – Financial Sector, Risks and Climate Change Email
To learn more
  • 02/16/2024 Foreword of the week
    Mobilising banks in the transition: supervisors must have better use of risk management

    The European Union is continuing its efforts to ensure that the banking system takes climate change into account. Banks will have to draw up a “transition plan”, according to the European Banking Authority’s (EBA) guidelines that are out for consultation until April.  One could hope that the banking authorities would seize this opportunity to encourage banks to better finance the transition, since their voluntary commitments are not sufficient. But the EBA does not make it a clear objective.

  • 02/14/2024
    Connecting the dots between climate risk management and transition finance

    A report to clarify linkages between these two approaches to climate action for the financial sector. The mobilization of the sector is necessary to help to finance the low-carbon transition. Some stakeholders thus advocate the explicit mobilization of the sector in favor of financing the transition. This rationale for action is known as the “transition finance approach”. The sector is also exposed to the financial risks arising from climate change and the necessary transition. This observation motivates a rationale for action known as te “risk approach”, aimed at managing the exposure of financial institutions to such risks.

  • 01/26/2024 Foreword of the week
    Failing to plan is planning to fail: Prudential transition plans and European Banking Authority consultation

    After nearly 4 years of negotiations, the European Union has just reached an agreement to reform the Capital Requirements Directive (CRD) for banks. The inclusion of climate change is a major step forward: banks will have to draw up prudential transition plans, supervised by the European Central Bank. These plans will complement the European regulatory architecture that is being put in place for large companies, with the Sustainability Reporting Directive (CSRD) and the Due Diligences Directive (CSDD). Are these banking transition plans a sufficient breakthrough to finally commit banks to climate neutrality? The answer to this question will depend on the implementation of EU legislation.

See all publications
Press contact Amélie FRITZ Head of Communication and press relations Email
Subscribe to our mailing list :
I register !
Subscribe to our newsletter
Once a week, receive all the information on climate economics
I register !
Fermer