A year ago, we published our 2021 climate scenario analysis update. That study helped us answer many of the questions around the investment implications of climate transition and physical risk.
It also built upon our earlier work that established a critical new way for us to integrate climate-related risks and opportunities into our investment processes and client solutions.
Scenario analysis involves modelling the effect of varying climate outcomes on asset prices – based on different climate policy and technology development paths.
How is our analysis different?
It’s not a standard ‘off-the-shelf’ solution. Instead, we expand our view by including more realistic bespoke scenarios tailored to include more nuanced sectoral and regional assumptions.
These can also be updated to consider credible changes in policy, technology and the structure of markets, as well as how companies are adapting to the energy transition.
By developing a large suite of scenarios, each assigned a probability, we also gain insights into the more likely ‘middle ground’. This provides more realistic insights than typical ‘tail-risk’ analysis, which helps investors make better decisions.
Time for another update
Some 12 months later and there’s been yet more evidence of the disparity between climate ambition and credible action – the credibility gap. This has helped shape our continuing innovation and latest update.
In Climate scenario analysis update 2022, we look at how new developments have emerged over the past year and how these have changed some of the assumptions that underpin the analysis.
Big 4 in 2022
Four things happened last year that have helped shape this update:
- The war in Ukraine – This conflict caused a surge in global prices that significantly increased the relative cost of energy derived from fossil fuels.
- Derailing of climate action – Governments were forced to rethink their energy and climate policies, with a greater focus on energy security and affordability.
- Economic forecast revisions – Analysts have been surprised by the strength of the post-Covid recovery. Revised views on the pace of economic growth have lifted the assumed long-term size and geographic composition of the global energy market.
- Changes in energy use patterns – The relative cost of renewable-energy technologies has declined more than expected. Renewables penetration and investment rates have increased faster since our last update. Assessments of future technological change have also become more optimistic.
Key takeaways
- Analysis upgrade
We’ve included ‘blending’ in our bespoke scenarios, making them more nuanced and realistic, and added a new scenario (Inevitable Policy Response); we’ve updated our ‘baseline’ scenario – that reflects what’s priced into the market – and the probabilities assigned to each scenario; we’ve changed the way we assess the probability of default for fixed-income investments.
- Changes to anticipated scale, speed, composition of energy transition
We think increased climate-policy ambition and cheaper low-carbon technology will result in greater decarbonisation and lower costs. However, we also expect higher energy demand overall, as well as higher gas demand in developing countries.
- Higher temperature in ‘mean’ scenario
Global temperature increases will hit 2.3°C (up from 2.2°C in our previous update) above pre-industrial levels in our ‘mean’, or most likely, scenario. That means the world is falling further behind on achieving the goals of the 2015 Paris climate agreement. Global policies aren’t providing enough incentives for investors to support climate goals.
- No change in regional, sectoral, decarbonisation leaders and laggards
Developed markets (DMs) achieve more decarbonisation progress than emerging markets (EMs). Within DMs, Europe achieves the most decarbonisation and the US the least. Among EMs, China is on a faster transition path than its EM peers. The power and transportation sectors lead the industry and buildings sectors. But there have been changes to the speed and completeness of the transition in different regions and sectors.
- Actionable insights in dispersion across and within sectors
Climate risk and opportunity is mostly a micro, or security level, phenomenon. Marginal impact at the sector level can hide significant variation at the sub-sector level. Take industrials for example, most airlines and marine companies are heavily impaired from large carbon costs that are difficult to abate. On the other hand, many electrical or construction & engineering firms benefit from increased demand for green infrastructure.
- Identifying credible transition leaders
This update includes corporate targets in the analysis. When combined with our separate climate credibility framework, we can consider the ambition of their climate plans and whether their actions live up to their words. Taking into account credibility-adjusted targets, can have a big effect on asset prices, particularly for firms in the utilities sector.