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How to get TCFD scenario analysis right

Author: ICAEW Insights

Published: 14 Dec 2022

With many of its underlying requirements open to interpretation, TCFD scenario analysis is a complex area for accountants to navigate. Here is an overview of the main guidance gaps, why they matter – and what companies should do to bridge them.

Increasingly, companies eager to demonstrate climate change awareness through their strategy and finances are integrating their reporting methods with recommendations set down in the strategic risk framework of the Task Force on Climate-Related Financial Disclosures (TCFD).

“When you integrate TCFD, the ideal output would be to provide a transparent, clear description of the resilience of your company’s climate strategy, taking into consideration different climate-related scenarios – including a 2°C or lower scenario,” says Jose Hopkins, Sustainability and ESG Director at MHA UK. “In order to show that you are aligned with TCFD, and to report an effective climate resilience statement, your financial disclosures must contain the execution and evaluation of a climate change scenario analysis.”

Hopkins describes it as a bit like going concern; it’s not a forecast for the future, but rather a way to identify quantitative and qualitative risks that might impact a business, given its current state, strategy and relevant climate factors that could evolve to affect it. “The idea is that you theorise a plausible, coherent and internally consistent situation that may possibly occur, based upon your particular starting points.”

Choosing a model that fits

TCFD scenario analyses require you to consider different climate scenarios covering the following main risk types:

  • Physical: Relating to how climate change could affect your supply chain, consumers and tangible assets – such as real estate, plants and machinery.
  • Transition: Relating to specific risks that may crystallise from the move towards a lower-carbon economy.

However, Hopkins notes, there is a fundamental problem. “When it comes to scenario creation, TCFD isn’t very strong on advice around how to consider different scenarios to describe the resilience of the strategy, so not many people understand how to approach it. For example, TCFD doesn’t stipulate how many scenario analyses you are required to produce.”

Indeed, TCFD essentially leaves companies and accountants to make up their own minds about how to lay the groundwork for their scenarios. While that process should be steered by a macro model of what climate conditions could look like in relevant locations at the date when the scenario is set, there are no rigid rules around this. Companies are free to either devise their own model – using internal and/or external expertise – or harness an ‘off the shelf’ model available from one of several key stakeholder bodies with significant interests in this arena, such as the International Energy Agency (IEA); the Intergovernmental Panel on Climate Change (IPCC); the Network for Greening the Financial System (NGFS), formed by 114 central banks; and the Bank of England.

At present, Hopkins notes, the two sets of scenarios that companies most commonly use are those published by the IEA and IPCC. The IEA’s offerings, he says, have become more useful since the organisation released its Net Zero Emissions by 2050 Scenario (NZE), which is compatible with a 1.5°C warming target.

In parallel, the IPCC has crafted two sets of scenarios: Representative Concentration Pathways (RCP) and Shared Socioeconomic Pathways (SSP). While the latter examples are more recent and robust, the former have been around for longer and are more established.

How companies wish to use such examples is entirely up to them. Hopkins explains that companies can even combine off-the-shelf models to ensure that the parameters of their own scenarios are informed by more than one perspective. “The IPCC’s models provide useful insights on physical risks,” he says, “while the IEA’s are useful for transition risks – particularly in relation to supply and demand of energy from different sources.”

Loose requirements

A further area of potential complexity is that TCFD’s advice is equally vague on which warming scenario companies should use to anchor their analyses. While it generally requires anchors of 2°C or below, 3°C scenarios are not unheard of. But which decimal should you land on? 1.7°C, perhaps? Or is it more like 1.9°C?

“The problem is, your chosen warming anchor affects the fundamental principle of comparability within the conceptual framework,” Hopkins notes. “Ideally, we would have literature that recommends which settings individual sectors should use. Currently, the most consistent industries are aviation and physical risk insurance. Why? Because companies in those sectors must file physical risk assessments with their relevant regulators – for example, aviation businesses must carry out and report physical stress tests under the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).”

As CORSIA has been active since 2016, aviation already has a strong basis for comparability. However, as Hopkins points out: “When we look at how companies in that industry are gauging transition risks under TCFD’s system, we start to see lots of variation. Why is EasyJet doing something different to Jet2 when they’re operating in the same sector?”

For Hopkins, the looseness of TCFD’s requirements, combined with low awareness of the underlying issues, could make for an uneasy cocktail of misapprehension. A recent PwC report said that 70% of boards don’t understand climate risks. “Going into TCFD without a grasp of the inputs is a risk all by itself. Not for corporates such as Coca Cola, Pepsi, BHP, Unilever or Rio Tinto, who have access to more than enough expertise, but for the vast majority of other businesses. Some 90% of the UK economy consists of SMEs. And they’re going to have to invest significantly – or hire external, specialist support – to bridge this knowledge gap.”

As an example of how that gap can materially affect companies, Hopkins explains that he often has to go back to FDs and explain: “I see you’ve used a net zero scenario – do you realise that, going forward, that means all your accounts under TCFD must be Paris aligned? That goes right to the heart of how you operate as a business, including your value chain.”

Focal point

It is clear that SMEs would be wise to seek external advice on these matters – but from a best-practice perspective, which initial measures should they take to cut through the fog and provide themselves with a baseline of experience in this field?

Hopkins says: “One very constructive step for any business to take would be to produce your own internal scenario analysis. Not to file under TCFD, nor for the scrutiny of any other external body – but purely for the benefit of your own company, to acquire some familiarity with this sort of work and identify factors that really matter to your business model.”

Harness one of the publicly available models, use it as a lens to examine your company’s strategy and see whether you identify any situations arising from the IPCC model that you should really consider going forward, Hopkins advises. If you can do a going concern model for your company’s balance sheet, you can create one for plausible climate scenarios.

“If you are able to define from a net zero perspective what each pathway means for your business – purely for yourself, not for outside observers – and produce an internal analysis that provides you with a focal point, that’s a great place to start.”

In the meantime, Hopkins believes that TCFD analysis in UK companies requires significantly greater attention from the government. “I had hoped that this would be a key area for the Transition Plan Taskforce,” he says, “In my view, the government must issue a pathway for each industry sector, based on UK demography for UK operations. As we’ve seen, it’s important for companies to start changing their cultures and mindsets if they are going to be able to produce these analyses. But I don’t think that will happen unless the government takes the issue seriously.”

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