The Power of Climate-Related Scenario Analysis: A Guide to Disclosure

What is Climate-related Scenario Analysis?

Scenario analysis is a process that businesses can employ to evaluate potential future events. In particular, climate-related scenario analysis focuses on events and futures related to climate change. The Task Force on Climate-related Financial Disclosures (TCFD) recommends all businesses utilize climate-related scenario analysis to explore how climate-related risks could affect their business and financial performance. Climate-related scenario analysis serves as a valuable tool, enabling businesses to anticipate the effects of climate change and other climate-related risks. This article will focus on the three proposed SEC disclosures that relate to climate-related scenario analysis.

In March 2022, the SEC released a document titled Fact Sheet: Enhancement and Standardization of Climate-Related Disclosures. This document includes proposed rules regarding disclosures related to “climate-related risks and their actual or likely material impacts on the registrant’s business, strategy, and outlook.” One of these disclosures would be for climate-related scenario analysis when “the registrant uses scenario analysis to assess the resilience of its business strategy to climate-related risks.” Required disclosures include:

“A description of the scenarios used”
“The parameters, assumptions, [and] analytical choices [that were used in the scenario]”
“Projected financial impacts [of the scenario]”

For further information on the SEC Fact Sheet, see our article on the proposed standardization of climate-related disclosures for investors.

In addition to the three disclosures above, the TCFD recommends a list of disclosures that share relevant information with stakeholders. These include:

How climate-related issues have affected business strategy
Material climate-related issues
Key performance indicators used to evaluate progress against climate-related targets
Consideration of climate-related issues for major capital expenditures, acquisitions, and divestitures

Each of these additional disclosures provide needed context and perspective for stakeholders. Companies seeking greater transparency regarding climate issues should consider disclosing all information necessary to apprise stakeholders.

Description of Scenarios Used

Entities that use climate-related scenario analysis should disclose basic information regarding the scenarios used. This information should include:

A description of the scenario narrative. Scenarios are hypothetical situations that describe a potential future. Explain the narrative of the particular future and the events that led to it to the stakeholders. Companies ought to explain the reasons for choosing the scenario.
The timeframe of the scenario. Since scenarios depict possible futures, explaining the time period they cover is crucial. When considering multiple timeframes and selecting just one, clarify the reasons for preferring it over the others.
The development process of the scenario. Companies should explain the origin of the scenario. Did the team create the scenario internally or externally? How many times did they revise the scenario? Were there any assumptions in the scenario that were controversial among those developing the scenario?
Important constraints of the scenario. Entities that use scenario analysis should highlight any weaknesses or constraints of the scenarios employed. Companies should explain the limitations of scenario analysis and that it is not a prediction of future events.

The TCFD recommends, at a minimum, that companies adopt a scenario that prevents global temperatures from rising more than two degrees Celsius above pre-industrial levels. It also encourages companies to incorporate multiple scenarios in their analysis and to create company-specific scenarios that tackle their unique challenges. Companies should disclose the above-mentioned points for each scenario utilized.

Analytical Choices and Assumptions Used in Developing Scenarios

Creating a usable scenario requires significant amounts of data and judgment. The TCFD advises companies to disclose the resources employed and the internal decisions made when creating a scenario for analysis. This disclosure should include:

Data sources used. Disclose the name and origin of any data sources used. Companies ought to justify their choice of data sources and describe the role each source plays in developing a scenario. For instance, if a company conducts a scenario analysis involving the impacts of extreme weather events, they should reveal that they obtained data from the National Weather Service due to its accuracy and reliability.
Analytical choices made. Creating a scenario requires professional judgment. Stakeholders should receive disclosures of any analytical choices that require significant professional judgment.
Important assumptions. Since scenarios are not predictions, creators will make assumptions that influence the scenario. Companies should disclose any assumptions they consider important to the scenario's outcome.

Disclosing data and assumptions provides more transparency to stakeholders that will help them understand the development of scenarios used.

Projected Financial and Other Impacts of Scenarios

One of the main goals of the SEC's proposed disclosures is the transparent disclosure of climate change's financial impacts. Two perspectives should guide the approach to the financial impacts of climate change:

Physical Risks - The potential financial implications of the scenarios analyzed
Transition Risks - The financial implications of changes in the company’s strategy due to climate change

Companies should first view the potential financial impacts of the scenarios analyzed and the physical risks associated with these scenarios. Climate-related events such as hurricanes, droughts, and rising sea levels will have financial impacts on companies. Entities that have important facilities located in areas prone to hurricanes should disclose the projected financial impact of losing those facilities. Companies should disclose the projected financial cost of relocation if they are based in locations that could be affected by rising sea levels. Companies should still disclose the underlying climate-related threat to stakeholders even if the risks are immaterial.

The second perspective that companies should consider are the financial implications related to changes in climate-related strategy, also known as transition risks. Transition risks are business-specific risks that emerge due to societal shifts towards a more environmentally friendly future. For example, there will be associated financial costs to install solar panels as companies choose to reduce their carbon footprint. The TCFD has identified four types of transition risks:

Policy and Legal Risks. Regulations relating to sustainability are constantly changing. Companies operating in multiple states and countries must comply with different laws. The uncertainty regarding future regulations makes risks relating to policies a business risk. Companies that fail to comply with regulations could end up in legal trouble, another regulatory-related risk.
Technology Risk. Changes in the climate will require changes in technology. Companies that can adapt will gain a strategic advantage, while those unable to develop new technologies may fall behind.
Market Risk. Market risks include such broad topics as changes to supply and demand or increased costs for materials and services. Shifts in consumer preferences may favor companies that sell environmentally sustainable products.
Reputation Risk. Public backlash may occur if companies appear unconcerned about climate change. Entities that resist adapting to climate change may face negative perceptions and financial consequences.

The TCFD also urges companies to disclose any future material climate-related issues. Most companies don't face immediate climate change threats, resulting in uninformative current disclosures due to immaterial present impacts. By explicitly disclosing potential future risks, companies grant stakeholders insights into the challenges they may encounter.

Microsoft's Use of Climate-Related Scenario Analysis

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In Microsoft’s 2021 Climate Change Questionnaire, the company outlined its use of climate-related scenario analysis. Although issued before the SEC’s Standardization document, the report follows the same pattern by disclosing the scenarios used, data and assumptions utilized, and projected impacts of the scenarios.

Microsoft begins by describing the scenario used in its analysis. The company explains that the “IPCC RCP 8.5 scenario” was the basis for its climate-related scenario analysis. The “IPCC RCP 8.5 scenario” is one in which global temperatures rise “over 4 degrees Celsius above pre-industrial temperatures.” Target chose this scenario because “it represents a business-as-usual scenario” and shows the “worst case for physical impacts through 2030.” Microsoft additionally explains that it “ran scenarios for 2030 and 2060” and ultimately based its scenario analysis on the 2030 horizon as it was “long enough for variation in the models attributable to climate change to appear but short enough to be actionable within [its] current risk management.”

Microsoft then goes on to explain the data and assumptions used in the scenario. The dataset used to craft its scenario was the “NASA Earth Exchange Global Daily Downscaled Projections,” which was chosen because it allows for “forecasts that cover an area as small as ~25km^2.” The company outlined several assumptions consistent with the scenario that were considered: “water shortage from extended drought” and “coastal flooding due to sea level rise.” Seven stressors related to the scenario were identified, including “increased energy demand,” “extreme temperature changes,” and “sea level rise.”

After conducting its scenario analysis using the data, assumptions, and parameters mentioned above, Microsoft determined “none of these risks to be material or substantive” at the time of the report. While it acknowledged that the threat that climate change has on certain business locations, the company claims that “Microsoft is well capitalized and geographically diverse in customer markets and location of product/service delivery.” It explained certain mitigation measures that have been put in place to manage climate-related issues, such as “adjusting the schedule of backup fuel deliveries to accommodate potential shifts in timing, location, and intensity of hurricanes” and “developing alternative sourcing strategies in water-stressed locations,” as well as “diversifying electric supply options in locations prone to severe storms and outages.”

When considering non-financial impacts to its business, Microsoft considered three transition risks related to climate change: “increasing regulatory costs of GHG emissions,” “changing customer behavior and shifts in consumer preferences,” and “reputational [risk].” The most significant risk considered was reputational risk. However, Microsoft did not believe it “poses undue risk to Microsoft at this time, given [its] existing business practices” relating to carbon emissions.

Target Corporation (SEC Comment Letter Dec. 2021): Transition Risks And Scenario Analysis

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Target Corporation (“Target”) is an American retail chain. In a comment letter from the SEC, Target was asked to explain “the specific transition risks [they] considered” when creating its climate-related scenario analysis.

In its response, Target disclosed that it considered four transition risks identified by the TCFD when creating its climate-related scenario analysis:

Current and Emerging Regulation
Technology
Market
Reputation

For each of these four risks, Target extrapolated its reasons for considering each risk and how each one could potentially impact its business. These reasons range from concrete examples to more general trends and issues. Each provides insight into how Target created and evaluated its scenario analysis.

When describing the current and emerging regulation they considered, Target specifically mentioned “California’s Zero-Emission Vehicle regulation,” which requires entities to have “a minimum percentage of electric vehicle sales.” Target explains that this could negatively affect its logistics partners, who could pass on costs to Target. The company also considered the “current and evolving regulatory framework for electricity pricing,” including provisions to encourage more renewable energy production. As Target consumes energy to power its locations, changes regarding energy production and consumption could affect the price it pays for electricity.

Target sees the transition risks related to technology as being both beneficial and detrimental. While it is possible that “technology advances could affect [its] merchandise assortment,” Target does not view this as a significant threat to its business. Due to its status as one of the largest retailers in America, Target believes that “technology advances also present new opportunities to satisfy guest demand.” Target currently sells “the latest energy efficient consumer products available in the market” and believes that “demand for such products will continue to grow in the future.”

The overall market risk was considered the least impactful to Target, as changes would “likely impact [its] competitors in a similar fashion.” However, Target did consider how “oil price fluctuations could drive higher material costs for products that use petrochemicals – such as feedstocks, plastics, detergents, solvents, nylon, and polyester.” While those costs could potentially be passed on to Target, they see potential to “adopt merchandising, sourcing, or other strategies to manage any cost increase.”

The final risk Target considered was reputational risk. Target’s business could be negatively impacted if it is “not perceived as assisting the global effort to transition to a low-carbon economy.” Consequently, Target has chosen to voluntarily report “the goals [they] have established for reduction of greenhouse gas (GHG) emissions,” along with its “Corporate Responsibility (CR) report.” Target believes it has been proactive in reducing any reputational risk associated with climate change.

Conclusion

Climate-related scenario analysis is a powerful tool that companies can use to explore future possibilities. It enables companies to share potential climate-related risks with stakeholders while also sharing strategies to overcome them. Disclosures regarding the scenarios used, data utilized, and potential impacts of said scenarios are the current minimum standard that the SEC is looking to implement. Companies should prepare disclosures with the end user in mind, focusing on transparency and disclosing information that users find valuable.

Resources Consulted

TCFD, Scenario Analysis - https://www.tcfdhub.org/scenario-analysis/

Accounting for Sustainability, Climate Scenario Analysis - https://www.accountingforsustainability.org/content/dam/a4s/corporate/home/KnowledgeHub/Guide-pdf/A4S%20Guide%20to%20TCFD%20Climate%20Scenario%20Analysis.pdf.downloadasset.pdf

SASB, TCFD Implementation Guide - https://www.sasb.org/wp-content/uploads/2019/08/TCFD-Implementation-Guide.pdf?__hstc=105637852.c8aa5f78828a8ff22c16650ec62e93f8.1582824054969.1585058786292.1585132514669.7&__hssc=105637852.1.1585132514669

CDP, TCFD Scenario Analysis Guidance - https://assets.bbhub.io/company/sites/60/2020/09/2020-TCFD_Guidance-Scenario-Analysis-Guidance.pdf

CDP, TCFD Technical Supplement - https://assets.bbhub.io/company/sites/60/2020/10/FINAL-TCFD-Technical-Supplement-062917.pdf