Ortec Finance’s Flynn explains the role of climate scenarios in the investment process

by | Jul 25, 2023

Uncertainty is intrinsic to climate change. While the realities of the phenomenon are becoming increasingly apparent with each passing season, it is not clear just how fast or in what ways that change is occurring.

In the midst of such uncertainty, there is growing pressure on the global financial sector, from a regulatory, fiduciary and societal perspective, to understand its implications. This will in turn allow financial institutions to manage their exposure to these long-term impacts by integrating climate change into the investment process.

Financial institutions are turning to climate scenario analysis to identify climate change-related risks and opportunities to manage their exposure. Climate scenario analysis considers a range of possible future climate pathways as well as associated economic and market developments. This allows financial institutions to focus on identifying and evaluating climate-related financial risks that may arise from a changing environment. It facilitates a structured exploration of how certain climate-related financial risks could manifest for financial institutions – including pension funds, insurance companies, sovereign wealth funds, asset managers and banks – and their investment portfolios in the future.

Financial institutions considering utilizing climate scenario analysis have the option of:

  • drawing on publicly available scenarios developed by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS);
  • purchasing alternative scenario sets that are developed using different modelling methodologies and assumptions; and
  • developing their own bespoke scenarios to reflect their own specific views and assumptions.

The diversity of scenarios is creating confusion in the market as to how to select the most appropriate scenarios to achieve their objectives.

The most widely-utilized of these are the publicly available scenarios. The free accessibility of this category has meant that they have been successful in creating awareness of the need to manage climate-related risks and opportunities and also of the effectiveness of this tool in supporting long-term investment decision-making. However, the one-size-fits-all nature of publicly available scenarios poses many pitfalls, not least of which include herd mentality and a lack of diversity of opinion. If left unchallenged, this could become a driver of systematic climate risk.

This could be avoided by relying on a more diverse range of climate scenarios that are more representative of real-world dynamics and assumptions. Financial institutions could look to bespoke scenarios which do offer greater flexibility and granularity in incorporating specific views and detailed assumptions that are representative of an institution’s operating context. These models are resource-intensive, however, and can be complex and time-consuming to develop.

Alternative scenarios, against this backdrop, offer the most feasible option for financial institutions, particularly those who are resource-constrained but want to seriously address climate-related risks and opportunities within their investment process. Offered by specialist firms in a third-party capacity, alternative scenarios are off-the-shelf solutions that provide a more comprehensive range of parameters that can be used to supplement the publicly available scenario sets. Ortec Finance is one such provider of alternative climate scenarios and, in fact, pioneered this application of climate scenario modelling more than five years ago.

Increased availability of a wide range of climate scenarios, as long as they are plausible, can only be a positive influence in steering financial institutions away from group think and reducing the long-term financial risks of climate change.

To learn more about climate scenarios, download Ortec Finance’s latest whitepaper – Unlocking the true value of climate scenarios

By Andrew Flynn, Director Climate & ESG Solutions, Ortec Finance

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