Climate scenarios: a rigorous framework for managing climate financial risks and opportunities

This article was produced by Aberdeen Standard Investments as part of their valued Industry Partnership to Insurance Investor.

Climate change is one of the defining issues of our age. Its physical manifestations are negatively affecting ecosystems, human health, and economic infrastructure. And much more disruptive outcomes are coming, even if the world is able to keep global temperature increases to 1.5° above pre-industrial levels. Meanwhile, the growing array of policy initiatives, private sector commitments and technology advances aiming to constrain greenhouse gas emissions and limit climate change are profoundly changing energy systems and patterns of economic activity.

It is vital that investors understand how physical climate change and the energy transition affect the investment returns of the companies and markets they invest in. We believe that doing so will enable us to build more resilient portfolios and generate better long-term returns for clients. It is also increasingly demanded by asset owners and regulators.

At Aberdeen Standard Investments, our approach to climate scenario analysis is motivated by the view that a rigorous and transparent methodology is essential for making sound investment decisions, encouraging positive change at the companies we invest in, and achieving robust outcomes for our clients. There are three features that jointly differentiate ASI’s climate scenario framework from that of most other asset managers and allow us to fully integrate the results into our business strategy:

Bespoke scenario design – Climate scenarios are typically taken ‘off the shelf’ from expert outside agencies. While this facilitates comparability and can be useful for policy design, it comes at the expense of unrealistic assumptions about policy uniformity across regions and sectors that weaken their usefulness for investment integration and product development. By relaxing these assumptions we can build more plausible scenarios that better inform our assessment of climate risks and opportunities.

Macro and micro integration – Investment integration also requires a rigorous process for translating climate scenarios into financial impacts for all the assets we manage. Drawing on the expertise of our external partner – Planetrics – we do this in three stages:

• Our scenarios are converted into economic shocks like carbon taxes or physical damages that alter energy usage and the demand and supply of different products through time.
• Effects on asset value streams are then modelled as a function of firms’ exposures to these shocks, their ability to react to them in terms of abatement or adaptation, and the nature of competition in their industry and thus the ability to pass on any higher costs to consumers or gain market share at the expense of more impacted competitors.
• Finally, we generate impairment estimates for individual securities, using standard asset pricing models, which can be aggregated at sector, regional and portfolio level.
  
  

Probabilistic assessments – The financial implications of climate change and the energy transition will be determined by the evolution of regulation, policy and technology. However, these drivers are difficult to forecast over long horizons. It is critical to take this uncertainty into account and update our analysis as new information becomes available. We do this by:

• Specifying a wide range of plausible scenarios
• Assigning probabilities to each scenario based on the political economy and economics of mitigation;
• Pooling the results so that we can analyse how asset prices respond to the probability-weighted mean outcome, as well as tail outcomes; and
• Updating our scenarios and their probabilities on an annual basis.
  
  

Please click here to read the full paper.

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