Climate scenario analysis

Scenario generation: The need for more sophisticated and customisable climate scenarios

We focus on scenario generation in this article, as the first stage in the scenario analysis process – and one where we are seeing growing interest from banks and other financial services providers. Firms are seeking to generate richer, customised scenarios by widening the scope of scenarios to cover a range of time horizons, integrating physical and transition risk assessments into scenarios and expanding macro-economic detail of scenarios.

This interest is partially driven by more stringent scenario analysis and quantitative disclosure expectations in new regulations such as the ISSB’s climate-related disclosures, along with wider adoption and further development of TCFD. It is also being driven by firms wanting to better integrate climate scenario analysis into their strategic and business planning process. Firms are increasingly viewing scenario analysis as a valuable opportunity identification tool to inform commercial decision-making, rather than just a risk management tool to meet perfunctory regulatory requirements. To capitalise on this, firms need to create more sophisticated scenarios, which relate specifically to their own business and operating environment.

Challenges of developing customised climate scenarios

The NGFS (Network of Central Banks and Supervisors for Greening the Financial System), IPCC (Intergovernmental Panel on Climate Change), central banks and other regulatory authorities have adopted Integrated Assessment Models (IAMs), usually with a basis in the field of climate research. These include GCAM, REMIND-MAgPIE and MESSAGEix-GLOBIOM – all of which link energy systems with economic activity and global temperature outcomes, with varying degrees of emphasis on land use and range of ‘feedback’ effects considered. These generally have relatively reduced-form economic models, which generate useful parameters for a range of climate scenarios.

The outputs of these models provide a solid foundation for firms to build on to create their own climate scenarios. However, more sophisticated users such as banks invariably need to undertake significant work to expand the macro-economic detail required to fully quantify the impact of climate risks on those sectors and regions most applicable to them. This is shown in Figure 2 below, which breaks down the best practice process of generating sophisticated, firm-specific transition risk scenarios into three key steps.

Addressing the challenge

Although most banks and other financial institutions have well-developed macro-economic projection models and frameworks, many lack the capability to generate sophisticated climate scenarios ‘in house’. This includes limited ability to extract sufficient detail and data granularity for specific sectors for the scenarios published by the NGFS, IPCC and IEA.

The ideal solution to this challenge would be a suite of models covering all three steps shown in Figure 2. This would enable firms to match published scenarios, using steps 2 and 3 in Figure 2 as an expansion tool to add further granularity. Alternatively firms could deploy the entire suite to provide fully customised counterfactuals or alternative assumptions on technology, demographics, economic growth, policy or adaptation.

Having a sophisticated global climate model of this type has two significant benefits:

1. Enables a rich set of scenario narratives to be explored and customised, since users have full access to the parameters and levers within the model.
   
2. Generates a more detailed sector and country-level views than public climate models, revealing insights that are unavailable from more simplistic treatments of climate-sector links.

Our solution

KPMG’s Climate IQ scenario analysis tool addresses these challenges with a modular, end-to-end climate scenario modelling suite, mirroring the three steps outlined above. This enables the production of a huge array of bespoke climate scenarios covering more than 65 sectors across 141 countries in high resolution. This allows the full spectrum of potential macro-economic, transition and physical risk impacts to be explored and quantified.

Taking into account firms’ varying levels of climate modelling maturity and capabilities, Climate IQ can be deployed to provide users with a comprehensive solution for generating customisable scenarios, or to fill gaps in existing data and modelling frameworks.

Climate IQ’s proprietary Integrated Assessment Model (IAM) comprehensively links different climate pathways with energy systems and a sector-by-sector treatment of the economy – sharing a similar level of functionality and intellectual pedigree to the IAMs used by the NGFS, IPCC and other authorities.

Climate IQ not only enables rich scenario generation, with detailed sector and country-level overlays, but also offers full transparency, expert support and detailed documentation to help firms select the best scenarios for their business.

Setting you up for scenario success

Climate scenario analysis has the potential to deliver real strategic value for banks and financial institutions, particularly in relation to opportunities identification – from refining product offerings and revealing new markets, to highlighting cost savings and efficiencies. Getting this first stage of the process right, through sophisticated scenario generation, is critical to setting firms up for success in the subsequent stages of impact quantification and response evaluation.

Lastly, developing rich, customised scenarios that are tailored to the organisation in question also helps to increase engagement from a wide range of stakeholders, including frontline business units. This internal buy-in is critical to embedding scenario analysis into business planning and realising it’s full potential as more than just a risk management tool.

Climate IQ for banks and financial institutions

KPMG’s Climate IQ tool uses sophisticated economic and financial modelling that has been Independently reviewed by University College London and London School of Economics, combined with granular physical risk assessments, to quantify the credit risk impacts (PD & LGD), under highly customisable climate scenarios, on the following lending portfolios:

• Corporate loans
• Residential mortgages
• Commercial real estate
• Motor finance

Find out more

In our next article, we will focus on stage two of the climate scenario analysis process: impact quantification.

If you would like to discuss this topic further, please feel free to contact us. You can also view further relevant content on our website.