What is accounting for climate resilience?
At a basic level, accounting for climate resilience is about building the resilience of an organisation’s strategy to the potential risks and opportunities posed by climate change. Using climate-related scenarios to understand future implications, the insights are used to help build an organisational climate adaptation plan, enlighten investment decision-making, and inform the reporting of climate-related financial information. The focus here is the materiality of potential climate impacts on an organisation’s ability to create value in the short, medium or long term.21
An adaptation plan focuses on altering an organisation’s behaviour, systems, and business models. It is the process of adjusting to actual or expected climate change, and its effects to protect an organisation’s future economy and ecosystem. Impacts could include rising temperatures, flooding due to rising sea levels, or seasonal droughts. A drive to reduce the waste generated by an organisation is an example of an adaptation activity.
An organisation’s climate adaptation plan sits alongside the net-zero transition plan. A transition plan focuses on reducing and mitigating an organisation’s emission of greenhouse gasses (GHG) into the atmosphere. It, therefore, addresses the root cause of the problem rather than dealing with the effects. Net-zero GHG targets are an example of mitigation activity in an organisation’s transition to a lower-carbon economy. To learn more about GHG transitioning and net-zero planning read our report, ‘Accounting for Carbon’.22
Together, the two plans are the organisation’s outline of activities to deliver its climate strategy, as shown in figure 1.23
Scenario analysis
Scenario analysis, often referred to as scenario planning, is a management tool designed to allow organisations and firms to evaluate the efficacy of strategies, tactics and plans under a range of possible future environments.25
The TCFD recommendations set out five benefits of undertaking scenario analysis, shown in table 1.
The TCFD recommendations use the concepts of ‘exploratory’ and ‘normative’ scenarios, which are defined as follows:
Exploratory scenarios are ‘used to describe and explore a range of different possible futures’. They help assess potential strategy-related risks and uncertainties and test the resiliency of strategies to a wide range of future conditions.
Normative scenarios. ‘Scenario analysis starts with a preferred or desired future outcome and then back-casts plausible pathways from the preferred future to the present to inform decisions on what is needed to achieve that preferred future’. They are typically used for assessment and setting of specific targets and implementation plans.27
When assessing the potential climate impacts on an organisation, use exploratory scenarios first.
Scenarios support quality decision-making by allowing a group of stakeholders to interrogate possible actions and understand upfront the impacts and long-term consequences of different decisions. Once you have answered the climate change question ‘What is going on here?’, scenario planning asks:
What could happen?
What would be the impact?
The recommendation from the TCFD, under the disclosure ‘C’ strategy, is to, ‘Describe the resilience of the organization’s strategy, taking into consideration different climate-related scenarios, including a 2°C or lower scenario’.28
When creating climate impact scenarios, develop between two and four cases, based on average temperature rises. Any more will be confusing and counterproductive. Ultimately, these serve as plausible futures of the impacts of climate change on an organisation’s geographical locations.
Key scenario elements include the following:
Descriptions of alternative plausible futures (not predictions)
Significantly different views of the future (not variations of a single base case)
Movies of the evolving dynamics of the future (not snapshots of endpoints)
Specific decision-focused views of the future (not generalized views of feared or desired futures)
Products of management insight/perceptions (not of outside futurists)29
Make sure your scenario planning does not become too prescriptive. Margaret Heffernan notes that finance professionals need to be aware that ‘Models can become too rigid, and their makers so wedded to them as to become blind to disconfirming data’.30
When thinking about the art of scenario analysis, it is also worth remembering that we are dealing with metaphors. Erica Thompson, a senior policy fellow at the LSE Data Science Institute, wrote:
The value of metaphor is in framing and reframing the situation so that we can see it from a new perspective, make unexpected links and create stories and explanations that help us to think collectively as well as individually about the implications of the information we have.31
Mandatory regulation and future standards that include climate scenario analysis
The familiar language used by the TCFD in its disclosure recommendations and four pillars — governance, strategy, risk management and metrics and targets — is being incorporated into new regulations and standards in jurisdictions around the world. This includes the use of scenario analysis to inform climate-related disclosure on organisational resilience.
UK government mandatory climate-related financial disclosures
In the UK, mandatory climate-related financial disclosure requirements — under The Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 and The Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022 — were introduced for financial years starting on or after 6 April 2022.
Under the section on what the regulations require companies and LLPs to disclose, guidance from the UK Government’s Department for Business, Energy & Industrial Strategy (BEIS) includes:
(f) an analysis of the resilience of the business model and strategy of the company or LLP, taking into consideration different climate-related scenarios.32
When selecting scenarios, BEIS advises:
Scenarios may also include a 1.5 degree C scenario or a ‘business as usual’ scenario where temperatures are likely to continue on their current trajectory to reach over 2 degrees C (e.g., a 3.5 degree C scenario). Climate scenarios typically take account of the assessments of the Intergovernmental Panel on Climate Change and the targets of the Paris Climate Agreement to reflect a global average temperature increase within the range of 1.5 degrees C above pre-industrial levels, to and including 2 degrees C above pre-industrial levels.33
European Union’s Corporate Sustainability Reporting Directive
The Corporate Sustainability Reporting Directive (CSRD) was adopted by the European Parliament in November 2022. It builds upon the Non-Financial Reporting Directive (NFRD) by embedding sustainability and assurance within the annual reporting process through 12 European Sustainability Reporting Standards (ESRS) across the pillars of environmental, societal and governance (ESG). Companies already covered by EU sustainability reporting obligations will be expected to report using CSRD in 2025, for the financial year 2024.
The draft ESRS 1, General requirements, published in November 2022, introduces the importance of scenario analysis when dealing with ‘sources of estimation and outcome uncertainty’34 Within draft standard ESRS E1, Climate change, the use of scenario analysis is encouraged and the processes behind it when identifying climate-related impacts, risks and opportunities described as a disclosure requirement.
(c) climate-related transition risks and opportunities in own operations and along the value chain, in particular:
i. the identification of climate-related transition events, considering at least a climate scenario in line with limiting global warming to 1.5°C with no or limited overshoot.35
Climate-related scenario analysis is also encouraged in the understanding of future strategy and business model resilience within ESRS E1.
IFRS foundation International Sustainability Standards Board (ISSB)
The IFRS standard S2, Climate-related Disclosures (IFRS S2), is to be released in mid-2023. It is envisioned the standard would be ‘effective for annual reporting periods beginning on or after 1 January 2024 (meaning an entity would report its first sustainability related disclosures in 2025)’36
In March 2022, the exposure draft standard asked entities to use climate-related scenario analysis to assess climate resilience, especially to disclose implications on strategy, any significant areas of uncertainty, and capacity to adapt.37 The draft standard also asked for a description of the processes used to conduct the scenario analysis, including:
which scenarios were used for the assessment and the sources of the scenarios used;
whether the analysis has been conducted by comparing a diverse range of climate-related scenarios;
whether the scenarios used are associated with transition risks or increased physical risks;
whether the entity has used, among its scenarios, a scenario aligned with the latest international agreement on climate change;
an explanation of why the entity has decided that its chosen scenarios are relevant to assessing its resilience to climate-related risks and opportunities;
the time horizons used in the analysis;
the inputs used in the analysis, including — but not limited to — the scope of risks (for example, the scope of physical risks included in the scenario analysis), the scope of operations covered (for example, the operating locations used, and details of the assumptions (for example, geospatial coordinates specific to entity locations or national- or regional-level broad assumptions); and
assumptions about the way the transition to a lower carbon economy will affect the entity, including policy assumptions for the jurisdictions in which the entity operates; assumptions about macroeconomic trends; energy usage and mix; and technology.38
U.S. Securities and Exchange Commission (SEC)
In March 2022, the U.S. Securities and Exchange Commission (SEC) issued a proposed rule change on The Enhancement and Standardization of Climate-Related Disclosures for Investors39, for comment.
Within the proposed rule, the SEC defines the use of scenario analysis as follows:
(i) when applied to climate-related assessments, scenario analysis is a tool used to consider how, under various possible future climate scenarios, climate-related risks may impact a registrant’s operations, business strategy and consolidated financial statements over time; and that (ii) registrants might use scenario analysis to test the resilience of their strategies under future climate scenarios, including scenarios that assume different global temperature increases, such as, for example, 3°C, 2°C, and 1.5°C above pre-industrial levels.40
The proposed rule focuses on the use of scenario analysis to describe the resilience of an organisation’s business strategy.
Because any scenario analysis disclosure includes future events assumptions and forward-looking predictions, the SEC is considering the application of ‘safe harbors’ to this type of disclosure in line with the Private Securities Litigation Reform Act (PSLRA).41
Further updates around the proposed rule are due from the SEC later in 2023.
