Why a “one-size-fits-all” scenario analysis is not the solution

In an elaborate, Star Trek-themed commentary piece on “no win” climate scenarios, Daniel Brooksbank makes the case for an “off-the-shelf” and “one-size-fits-all” climate scenario approach for investors as a means of reducing both cost and effort. While a long-time admirer of Daniel’s analyses and thoughtful reporting, I must disagree with his view on this matter.
Imagine a world with just one brand of shoes available in just one style and size, allowing for much cheaper and easier production than having varied choices for styles and brands. While production may be cost-effective, the idea is, of course, a non-starter. You would never wear your dress shoes in the mud, high heels on the Starship Enterprise, rubber boots at your wedding, or sandals when climbing Mount Everest. And the same holds true for climate scenario analysis of investments.
Indeed, an investor should first determine their objectives and related perspectives (“what”), followed by the appropriate means (“how”).

The first step of a scenario analysis therefore requires determining an objective of what an investor wants to achieve, which results in choosing the analysis perspective. There is a fundamental difference in scenarios that deal with transition risk (i.e., the world is moving towards a 1.5-degree target with implications for high-emitting sectors and companies) versus scenarios that deal with physical risks where the effects of climate change hit supply chains, production facilities and markets in a “no win” scenario. There is an important difference in running scenarios regarding a portfolio alignment with a future decarbonized world (i.e., transition in line with the world) and scenarios for portfolios aiming to contribute to such decarbonization.Once the perspective has been determined, the investor needs to choose the appropriate approach and parameters: Is this a portfolio-level analysis or do I want to check individual assets? Will I focus on specific sectors with specific approaches or do I use parameters that can be applied to any company, such as target setting, across sectors? Is my scenario quantitative, typically measured in greenhouse gas emissions or unit of future output? Or is it qualitative, focusing on strategies, targets, risk management, etc.? Do I choose a bottom up approach with asset-level data or a top down view such as sectoral changes or international weather patterns? And, quite importantly, what timeline do I apply? Do I look out only five years, which allows for more nuanced modeling, or do I take a long view in line with the challenge and choose a timeframe out to 2050?
To address these important questions, investment climate scenario analysis can’t take a one size fits all approach. It requires embracing the logic and consequences of future climate change implications and drawing conclusions that are relevant for the individual asset management approach and philosophy. Also, the scenario solutions out in the market are only a start. Climate scenario analysis is in its infancy and will get more sophisticated over time – but only if we develop several approaches in a positive competition with each other, rather than calling for a uniform standard. This approach might not be as cost-effective as settling for an off-the-shelf solution, but, if done right, will be well worth the investment and, dare I say, an approach that Mr. Spock would approve.

Maximillian Horster is Managing Director at Institutional Shareholder and Head of its ISS-climate division. This commentary is derived from Climate Scenario Analysis for Investments, available here.