Climate-Related Scenario Analysis: Where Sustainability Meets Financial Analysis

In the dynamic realm of corporate sustainability, the Task Force on Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB) have emerged as pivotal frameworks*. They advocate for the inclusion of both qualitative and quantitative data in financial reporting. However, many companies still neglect the integration of quantitative and financial data into their sustainable reports, which is a critical issue that needs addressing.

*In 2023, the International Sustainability Standards Board (ISSB) assumed the mantle of overseeing companies' climate-related disclosures, taking over from the Task Force on Climate-related Financial Disclosures (TCFD). Despite this transition, the predominant framework for climate-related scenario analysis continues to mirror the structure laid out by the TCFD. Therefore, for the purposes of this article, we will continue to reference this analytical approach as TCFD analysis.

Bridging Sustainability and Finance: How ISSB and TCFD Aid Investors and Bankers in Decision-Making

This article bridges the gap by offering practical guidance on developing financial models aligned with TCFD scenarios. We illustrate the process through examples and diagrams, enabling organizations to incorporate climate-related risks and opportunities into their financial analysis. By harnessing TCFD-driven financial scenario analysis, companies can enhance disclosure practices, allowing investors and banks to make informed financial decisions that drive sustainable value creation and investment.

The Significance of Quantitative Analysis:

Quantitative analysis is the foundation of TCFD Scenario Analysis. It enables organizations to move beyond qualitative assessments and into data-driven decision-making. By quantifying the financial impacts of diverse climate scenarios, organizations gain clarity on potential outcomes, allowing proactive risk management and strategic adaptation.

Companies must integrate these risk factors and green financial items into their financial analysis to perform a comprehensive cost-benefit analysis for decarbonization. By doing so, they can accurately assess the financial impacts of their sustainability initiatives, enabling more informed decision-making and strategic planning to achieve both environmental and economic goals.

Diagram 1: Examples of risk factors and green financial items to integrate into financial analysis

A typical disclosure flow involving the TCFD Scenario Analysis Framework is illustrated in diagram 2. There is a distinction between the large corporations' and SMEs’ approach that should be noted.

Diagram 2: Disclosure flow for corporations utilizing the TCFD Scenario Analysis Framework

Steps Towards Effective TCFD Scenario Analysis:

1. Governance Development

2. Assessment of Risk Importance

3. Definition of Scenarios

4. Business Impact Evaluation

5. Definition of Measures

6. Documentation and Disclosure

These steps can be done simultaneously if necessary.

Governance Development: Integration of scenario analysis into strategic formulation and risk management processes, ensuring active management involvement and stakeholder engagement to shape scenario selection and evaluation. Due to its intensive nature, there needs to be active management involvement to ensure the success of sustainability disclosure.

Assessment of Risk Importance: Understand and prioritize anticipated climate risks and opportunities, assessing their significance from industrial and organizational perspectives.

TCFD outlines two main types of risks: transition risks (caused by climate change responses in each country) and physical risks (caused by climate disasters such as droughts and floods).

Diagram 3: Examples of different climate-related risks

To begin, companies should identify general risks faced by the region and competitors in the same industry before highlighting any notable differences specific to the company. This tailored risk analysis is more suited to the company.

It is crucial to evaluate company-specific risks and opportunities in the context of climate change. Organizations need to conduct a comprehensive assessment of internal and external factors that shape their exposure to climate-related risks and opportunities. By identifying industry-specific vulnerabilities and potential avenues for innovation and competitive advantage, organizations lay the groundwork for targeted risk management and strategic planning.

Diagram 4: Illustrates how to develop company-specific risks

Definition of Scenarios: Carefully define the scope of scenarios used for the analysis, making sure to proceed with clear knowledge of market trends and future government policies.

• Consider the different PEST factors (Political, Economic, Social, Technological) that will impact the scenario setup.

• Incorporate unique company factors into general scenarios (available on the TCFD website) for analysis.

Diagram 5: Illustration of how different PEST factors can affect the numbers that make up each scenario analysis

Develop future trajectories encompassing various climate, regulatory, and market conditions. Consider scenarios ranging from ambitious climate action to business-as-usual, enabling comprehensive risk assessment and strategic planning. Pay special attention to the 1.5 and 4-degree scenarios highlighted by TCFD.

Business Impact Evaluation: Quantitative assessment of the financial implications of each scenario on revenue, costs, and profitability enables informed decision-making and strategic planning.

After setting the stage through climate-related risk assessment and defining scenarios, it is time to translate them into numbers for financial analysis.

Financial items identified through the risk assessment and scenario definition stages will be quantified here.

Diagram 6: Illustrates how financial items affected can be quantified

These quantified financial items should be incorporated into financial statements to calculate the net income of the organization. The quantification of financial items affected allows investors to understand how much climate-related risks and scenarios can affect a company’s financial performance.

Diagram 7: Illustrates how the scenario and risk assessment can be quantified in financial statements

Through rigorous analysis and modeling, organizations quantify the financial implications of diverse climate scenarios, predicting potential revenue fluctuations, cost structures, and risk provisions. By integrating climate-related variables into financial modeling frameworks, organizations gain actionable insights into potential outcomes, enabling informed decision-making and strategic planning.

Diagram 8: Illustrates impact on financial statements

Definition of Measures: Formulation of actionable countermeasures to mitigate identified risks or capitalize on emerging opportunities.

These measures can be split into 2 sections: business opportunities and Sustainable Performance Targets (SPTs) to counter climate change.

Sustainable Performance Targets (SPTs) are specific, measurable goals that organizations set to improve their environmental, social, and governance (ESG) performance over a certain period. These targets are integral to a company’s sustainability strategy, aiming to reduce negative impacts and enhance positive contributions to society and the environment.

Documentation and Disclosure: Document the process and communicate with relevant organizations, presenting information on key input variables, assumptions, analytical methods, results, and possible management options.

Conclusion

To make informed financial decisions, investors and banks need comprehensive financial data and quantitative insights on the cost-benefit analysis of decarbonization efforts. Critical financial details, such as internal carbon pricing, damage insurance, and Green Capital Expenditures (CapEx) for decarbonization, are often omitted from traditional financial statements.

Most importantly, investors and banks require a clear understanding of the financial impact on the bottom line. Ultimately, they need to thoroughly analyze the costs and profitability associated with decarbonization initiatives to guide their investment and lending decisions effectively.

Part 2: Case Study: Holcim - Sustainability Disclosure for Investor Communication

Stay tuned for Part 2, where we dive deeper into Holcim's strategies, their quantitative assessments, and the actionable measures they have implemented to address climate-related risks and opportunities. Holcim, well-known for producing exemplary sustainability disclosures, offers valuable insights into effective practices for integrating climate-related data into financial decision-making.

REANGLE Services

REANGLE extends its Green Finance Consulting services to institutional investors and corporations across Southeast Asia, Japan, and beyond, harnessing Singapore’s pool of talent. With global sustainable finance platforms and highly motivated green talent, REANGLE delivers Green Finance Analysis and Green Data Analytics services quantitatively, alongside providing Green Investor Relations advisory service to drive authentically sustainable investment decisions.

Do check out REANGLE’s past articles for further clarification or reach out to us at kazu@reangle.co (Kazu Watanabe).