Scenario analysis may be a key part of climate-related disclosure obligations, but uncertainty about how to use these tools represents a challenge for investors, says Sustainable Fitch.
In a new report, the company said issuers, regulators and financial institutions are increasingly using scenario analysis to evaluate companies’ physical and transition risks due to climate change.
“For investors, scenarios are becoming a critical tool for managing climate-related risks and for informing portfolio strategies,” it said.
However, the limitations of scenario analysis, and a lack of understanding about the results is hampering its utility, Sustainable Fitch suggested.
“Our research shows that mainstream climate scenarios are open to misinterpretation and sometimes underestimate climate risks, which could create interpretation risks for investors,” it said.
Specifically, the firm said investors often don’t fully comprehend the limitations of scenario analysis.
“Seemingly similar pathways — e.g. 1.5°C scenarios — can produce wide variations in projected demand for particular technologies, depending on the scenario’s underlying assumptions and the models used,” it said, adding that a lack of standardization makes it difficult to compare results between companies.
“Current models also exclude or underestimate significant risks, those emanating from non-linear events like climate tipping points or macroeconomic and financial second-order effects,” it noted.
According to Sustainable Fitch, as the limitations of scenario analysis is more widely recognized, “regulators may adjust their use of climate scenario analysis to help surface better systemic risks and start to inform supervisory and regulatory actions.”