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Climate scenario analysis as a means for portfolio alignment

The proliferation of climate risks has necessitated urgent global action with regard to achieving net-zero goals. Financial institutions are growing increasingly concerned with climate risks, and for good reason. In the case of banks, climate risks add to credit risks by affecting debt serviceability, as well as the value of collateral backing the loans. Moreover, they can also compound market risks of portfolios that are exposed to climate hazards as the economic value of financial assets can be negatively affected, resulting in price reductions and impact on return on investment.

A remedial measure has emerged in the form of climate scenario analysis. Indeed, it has become an important forward-looking management tool for financial institutions to assess the progress of their counterparties in managing climate risks, thereby aligning their portfolio to climate goals such as net-zero or 1.5°C. An effective application of scenario analysis involves identifying plausible exposures that can materialise as risks, defining scenarios based on material exposures, assessing financial impact, and finally, identifying potential responses. Climate scenario analysis enables financial institutions in mapping strategies for client engagement, reporting, developing new standards and practices, and meeting regulatory obligations. Essentially, it is an exercise in assessing how well-placed financial institutions are in imminent transition scenarios.

Widespread acceptance of climate scenario analysis by the financial sector is credited to the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) in 2017. Consisting of over 100 members, the NGFS has developed a range of hypothetical scenarios on the basis of whether climate goals are met. Similarly, the International Energy Agency (IEA) has developed scenarios that examine future energy trends. These are based on declared policies as well as goals such as net-zero and sustainable development. Along similar lines, the climate scenarios of the IPCC help in mapping a future with net-zero carbon emissions, one with twice and even thrice the current carbon emissions.

A pertinent example is of the largest customer-owned pension fund in Denmark, PFA Pension. With over USD $94 billion in customer funds, PFA Pension has set an ambitious target of reducing 29% of CO2 emissions from its listed equities, properties and credit bonds by 2024. The fund employs climate scenarios developed by the IEA to gain a macroscopic view of its portfolio. It hopes to understand which companies in its portfolio face significant climate risks by focusing on the different energy mixes under different scenarios of the IEA. Moreover, the fund has also developed an internal screening tool to comply with the Paris Agreement goals in its investment process. This consists of evaluating all listed equities and bonds held by the fund on the basis of their carbon emissions, thereby identifying the companies which either emit more carbon than the sector or are reliant on energy intensive sectors. As such, PFA Pension divested seven companies in 2019 due to their failure to comply with its climate requirements.

Tools for climate scenario analysis

The purported climate scenarios by NGFS, IEA or IPCC act as a launchpad for climate scenario analysis tools. These tools are also evolving to align with climate scenarios. While such tools are incredibly important in setting targets for portfolio management, they are also instrumental in informing decisions about capital allocation, budget setting, and product structuring, amongst others.

The Paris Agreement Capital Transition Assessment (PACTA) is one such tool. It allows financial institutions to assess the degree of alignment of their portfolio to climate scenarios consistent with the Paris Agreement. It compares the institutions’ exposure to carbon-intensive companies with decarbonisation scenarios of corresponding sectors. The differentiator of PACTA is that it measures alignment according to sector and further, production plans of companies involved in the sector. This is particularly relevant as the Paris Agreement calls for varied action from different sectors.

With increasing climate risks, incorporation of climate scenario analyses in the financial sector is imperative to reduce exposure to corresponding sectors and companies. Moreover, it is especially important as it influences decisions on financial flows to climate action.