Climate change is one of the defining challenges of our era. The complex impacts it unleashes will produce significant new risks and opportunities for business. The Task Force on Climate-Related Financial Disclosures (TCFD) has called on all public companies to report on climate risks and how they address them in mainstream financial filings.
Since climate risk is systemic and applies across all sectors, the TCFD recommends that companies with annual revenues over US$1 billion report climate risks in non-financial reports in preparation for the day when these systemic risks become material. Engaging with the TCFD recommendations today serves two purposes: (1) reporting to external stakeholders and (2) creating resilient business strategies through scenario analysis.
On the first front, the TCFD recommendations bring a great benefit to sustainability practitioners by potentially unifying the fragmented landscape of climate reporting, with alignment with CDP, GRI, and SASB underway. Over 290 companies and organizations now publicly support the recommendations; 18 companies have expressly committed to implement them as fully as practicable over the next three years.
But it is the second purpose—the development of resilient business strategy through scenario analysis—that gives the most added value for companies engaging with the TCFD.
"The TCFD recommendations do an excellent job of helping an organization evaluate and communicate the risks associated with a changing climate,” said Bruno Sarda, VP of Sustainability at NRG Energy. “Beyond risk mitigation, the use of scenario analysis can help an organization identify opportunities to bolster its strategic resilience and relevance, ensuring that it can thrive not only today, but well into the future.”
Scenario analysis has been used for decades by business and government to improve decision-making under conditions of uncertainty. Rather than basing decisions on single-point forecasts, under scenario planning, companies consider a set of plausible alternative futures to shape more adaptive and resilient strategies.
While we can increasingly predict the aggregate physical impacts of climate change, the secondary and tertiary impacts are inherently challenging to model. For example, it is highly plausible that drought and extreme weather events will cause large-scale human migration with destabilizing sociopolitical impacts—but this is not something that can be predicted with accuracy. Given how consequential these cascading impacts will be, business should use scenario analysis to start considering them now.
Here are our suggestions for how companies can implement the TCFD recommendations to both engage with stakeholders and improve their strategies.
1. Approach scenario analysis primarily as an opportunity to improve strategic resilience
The primary objectives of climate scenario analysis should be to grapple with the uncertainty of climate impacts, challenge a company’s own potential blind spots about the future, and modify business strategies to make them more robust and resilient. We believe firms should disclose the scenarios they are using, key assumptions contained in those scenarios, and information about plausible risks and opportunities for the business. At the same time, disclosure should not prevent an honest and challenging internal appraisal of business strategy.
As the EBRD and the Global Centre of Excellence on Climate Adaptation state, “the ultimate objective in disclosing the use of scenarios is to build investor confidence that a company is meaningfully engaged on the topic of climate change, that it is looking at a broad range of outcomes and is responsive and proactive, rather than defensive and reactive.”
2. Consider a broad range of climate risks and opportunities
We urge companies to take an expansive view of the potential risks and opportunities they may face. While much of the initial conversation around the TCFD recommendations has emphasized transition risk faced by companies in high-emitting sectors should emissions be reduced along a 2°C scenario, equal consideration must be given to the physical risks of climate change, which will be highly disruptive even if warming is held to this level.
Many of the most profound challenges associated with climate change lie in the cascading social, economic, and political changes that will result from physical impacts and are inherently hard to model or quantify. For example, climate-driven human migration, political conflict, economic dislocation, and changing disease patterns will have major implications for society and business. Scenario analysis offers an important opportunity to think about those risks and opportunities that are not easily built into current models.
3. Use scenarios tailored to the business and leverage data from diverse sources
Finally, although comparability in financial disclosures is important, scenario analysis is most effective when tailored to the specific circumstances of an individual company. An energy company may be most concerned about the uncertainty of inbound climate regulation, whereas a consumer products company may be most focused on the uncertainty of physical climate impacts on its agricultural inputs.
Each source of information, including the IEA’s New Policies Scenario and Sustainable Development Scenario, has its unique strengths and limitations. Were all companies to use the same scenarios, based on the same assumptions, they could inadvertently create the kind of economywide risk the TCFD recommendations seek to prevent. Using a diverse set of scenarios reduces the possibility that everyone will be wrong in the same way.
While we agree companies should include at least one scenario that correlates with a 2°C world and another with a higher-temperature world, they should choose scenarios that play out the critical uncertainties that are most relevant to their businesses. It is important that these be plausible and challenging in grappling with the uncertainty of systemic climate risk and do not provide a false sense of security by ignoring the potential for disruption.
The ultimate purpose of the TCFD recommendations is to better prepare the private sector to understand and prepare for the uncertain impacts of climate change. Businesses should approach implementation not merely as a disclosure exercise, but as an important opportunity to enhance their strategic resilience.
If you’d like to discuss this in greater detail, please join us on July 26 at the Japan Conference on the TCFD Recommendations.