Quantitative Analysis for Green Finance

The emergence of the International Sustainability Standards Board (ISSB) is reshaping how companies report their environmental impact, as well as how investment analysis is performed. In particular, it enables a more quantitative approach to analyzing climate-related financial disclosures.

This article will delve deeper on scenario analysis and the integration of sustainability-related factors into financial statements.

Scenario Analysis

Scenario analysis is a ‘what-if’ analysis that explores the potential impacts of sustainability-related risks and opportunities. It helps answer questions such as “How would the demand for the company's products be in the different climate change scenarios?” or “What are the significant climate-related costs that the company would incur in a low-carbon economy?”

IFRS S2 mandates the use of scenario analysis for resilience assessment, in which its application guideline is built on the TCFD recommendations.

There is No Standard Methodology for Scenario Analysis

ISSB allows companies to choose their own approaches to scenario analysis based on their level of exposure to climate related risks, as well as the skills, capabilities, and resources available.

It is worth noting that, although most companies' scenario analyses are currently primarily qualitative, ISSB expects a shift towards increased quantification over time, especially for companies with significant exposure to climate-related risks.

Given the complexities and nuances of climate-related risks, there is currently no standard set of methodology employed by companies to perform scenario analysis. Nonetheless, one reliable source of guidance is the TCFD framework, which outlines six essential steps:

1. Ensure governance is in place

2. Assess materiality of climate-related risks

3. Identify and define range of scenarios

4. Evaluate business impacts

5. Identify potential responses

6. Document and disclose

Source: TCFD

Understanding the 1.5°C and 4°C Scenarios

One common set of scenarios that companies can use is the 1.5°C and 4°C scenarios.

The 1.5°C scenario represents a scenario in which climate change is effectively mitigated through significant collective action. It assumes that governments, organizations, and individuals take substantial actions to reduce greenhouse gas emissions, transition to renewable energy sources, and implement sustainable practices.

This warrants large transition risks related to climate-related regulations. Hence, companies would need to shift their efforts into decarbonization and developing low carbon products to align with customers’ expectations.

Conversely, the 4°C scenario depicts a world where minimal action is taken to mitigate climate change. This leads to a future characterized by frequent and severe extreme weather events, rising sea levels, and disruptions to ecosystems.

This warrants significant physical risks. Companies face increased costs stemming from climate-related damages and thus, would need to put significant efforts into climate adaptation.

Source: REANGLE

The performance and prospects of companies under those scenarios will vary according to their business models and approaches to sustainability. Below are two examples:

1.5°C Scenario	4°C Scenario
Solar Panel Producer
Increased revenue due to high demand for renewable energy May receive government grants due to policies promoting clean energy Challenges related to competition and the need for ongoing innovation in solar technology Albeit minimal, introduction of carbon taxes could increase cost	More frequent and severe extreme weather events may disrupt the supply chain, impacting the availability and cost of critical materials and components needed for solar panels Uncertain demand for solar panels as society focuses on climate adaptation rather than mitigation
Food Manufacturer
Potential to introduce new product lines focused on plant-based or alternative protein options More predictable weather patterns can enhance crop yields and supply chain stability Easier access to certification and labeling programs for sustainable and organic products The need for investment in water-efficient and energy-efficient production processes Potential for cost savings through recycling and waste reduction	Climate change-induced extreme weather events will disrupt supply chains, leading to increased volatility in raw material prices and availability Increased demand for emergency and long-lasting food products in regions affected by climate-related disasters Water scarcity and energy disruptions may increase production costs Increased research and development costs related to high-temperature-tolerant crops

Quantitative Scenario Analysis is Challenging

To quantify the risk and opportunities identified while performing scenario analysis, companies can decide on the calculation method they deem appropriate. For example, to quantify the impact of carbon tax introduction, the company can use their GHG emission level and carbon tax price.

However, performing quantitative scenario analysis is exceptionally challenging in practice. This difficulty holds true even for large companies.

For instance, let's take the example of a logistics service provider identifying flooding as a physical risk. While the company is aware that floods can lead to revenue reduction due to operational shutdowns and the write-down or write-off of assets, estimating the potential damage is a complex task. The company may face challenges in several areas:

1. Flood Probability: Estimating the probability of a flood occurring in its specific geographical location can be difficult, especially if there is insufficient research or data available. Climate modeling and local environmental conditions are complex, making it challenging to predict with precision.

2. Amount of Potential Asset Write-offs or Write-downs: This involves considering the value of assets, depreciation, insurance coverage, and other factors, and these calculations can be intricate and uncertain.

Understanding Scenario Analysis Through a Case Study of Holcim

Holcim is a global building and construction materials company headquartered in Jona, Switzerland. Some of the products and services it offers are sustainable building solutions, low-carbon concrete (EcoPact), and low-carbon cement (EcoPlanet).

Given the absence of a standard methodology and the inherent challenges in quantifying the financial implication of risks and opportunities, smaller companies can often benefit from learning from the experiences of larger organizations. A valuable example is the scenario analysis conducted by Holcim.

Holcim considered two scenarios in their analysis:

1. “Paris Agreement-aligned” scenario (1.5°C)

2. “Ineffective Collective Action Against Climate Change” scenario (2.7°C - 4.4°C)

The picture below is a summary of Holcim’s scenario analysis.

Source: Holcim

Holcim has also provided good explanations on the risks and opportunities it identified. It explains why it has identified them, how they affect its business, as well as the steps it is taking to minimize the negative effects and take full advantage of opportunities.

Source: Holcim

Holcim’s scenario analysis concluded that the Paris Agreement-aligned scenario is more favorable for the company. This is attributed to the fact that Holcim's unique selling proposition (USP) revolves around sustainable construction solutions and materials. Furthermore, the company is already on a promising trajectory toward achieving its net-zero emissions target by 2050.

While Holcim's analysis remains predominantly qualitative, it serves as a valuable source of insights for smaller companies. These insights include how to structure and analyze scenarios effectively, pinpoint essential risks and opportunities, and devise strategic plans for potential future conditions.

Integrating Sustainability-Related Data into Financial Statements

FIs have several methods for incorporating sustainability-related data into investment analysis, one of which involves adjusting financial projections.

Similar to scenario analysis, there is no one-size-fits-all methodology. Extensive understanding of a company’s value chain, internal processes, as well as disclosure requirements is needed to pinpoint material factors and determine the best methods for quantifying them.

Potential adjustments that can be made include:

• Anticipating higher future capital expenditures related to investments in low-carbon technologies

• Accounting for impairment costs stemming from the early retirement of carbon-intensive assets

• Modifying sales growth forecasts to reflect products that support the transition to a low-carbon economy

• Recognizing additional costs incurred due to the introduction of carbon taxes

• Factoring in an increase in insurance premiums for climate-change vulnerable assets

However, there are practical challenges in the process of integrating climate-related factors into financial statements.

These challenges encompass inconsistent data, incomplete data, uncertainty in the reliability and accuracy of unaudited data, high-degree of subjectivity, and incomparability of those factors across companies, industries, or geographies.

ISSB aims to address some of the aforementioned issues, particularly inconsistent data and incomparability. Nevertheless, the issue related to subjectivity remains.

One way to tackle this is through case studies. Alternatively, with our extensive knowledge on green finance metrics and experience in financial analysis and modeling from a green finance perspective, REANGLE can provide valuable assistance in navigating these challenges.

About REANGLE

REANGLE offers Green Finance Consulting services to institutional investors and corporations in Southeast Asia, Japan, and beyond by leveraging Singapore’s talent. Currently, REANGLE provides Green Finance Analysis and Green Data Analytics services, as well as conducts Greenwashing Risk Assessments to drive authentically sustainable businesses and investments.