Climate Scenario Analysis
Executive Summary
Key Takeaways
- ✓ Climate scenario analysis constructs multiple, internally consistent narrative and quantitative pathways against which a financial model's climate exposure is tested, rather than a single assumed future.
- ✓ Each scenario should be built from an explicit narrative, the qualitative story of how the transition or physical climate pathway unfolds, paired with the specific quantitative macro variables (carbon price, temperature pathway, policy stringency) that narrative implies.
- ✓ Transition and physical risk scenarios should be paired rather than modelled in isolation, since an orderly, rapid transition scenario typically implies lower long-run physical risk, while a delayed transition scenario typically implies higher long-run physical risk, a relationship a model should represent rather than treating the two risk types as independent.
- ✓ Constructed scenarios should feed directly into the entity or portfolio-level loss estimation covered in climate risk financial modelling, rather than remaining a separate narrative exercise disconnected from the quantitative risk model.
- ✓ Scenario probability weighting, where used, should be disclosed as an explicit assumption in its own right, since it reflects a judgement about the relative likelihood of different future pathways, not an objective input.
Objective¶
This guide covers constructing climate scenarios within Climate Finance & Climate Financial Modelling, feeding directly into Climate Risk Financial Models' portfolio-level loss estimation.
Narrative and Macro Variable Construction¶
Each scenario should be built from an explicit narrative, the qualitative story of how the transition or physical climate pathway unfolds, paired with the specific quantitative macro variables that narrative implies: carbon price trajectory, temperature pathway, and policy stringency among the most common. A scenario presented only as a set of macro variables, without the narrative logic connecting them, is difficult to assess for internal consistency.
Pairing Transition and Physical Scenarios¶
Transition and physical risk scenarios should be paired rather than modelled in isolation. An orderly, rapid transition scenario typically implies lower long-run physical risk, since aggressive near-term mitigation reduces the physical hazard severity that later materialises, while a delayed transition scenario typically implies higher long-run physical risk. A model that treats Physical Climate Risk Models and Transition Risk Models as fully independent misrepresents this relationship.
Feeding Portfolio-Level Risk Quantification¶
Constructed scenarios should feed directly into the entity or portfolio-level loss estimation covered in Climate Risk Financial Models, providing the specific quantitative inputs that loss estimation runs against, rather than remaining a separate narrative exercise whose outputs are not actually connected to the quantitative risk model.
Scenario Probability Weighting¶
Where scenario probability weighting is used, rather than presenting a simple unweighted range, the weighting basis should be disclosed as an explicit assumption in its own right. A probability weight reflects a judgement about the relative likelihood of different future pathways, and presenting it without disclosure embeds that judgement invisibly inside what appears to be a mechanical calculation.
Common Construction Pitfalls¶
Macro variables presented without a connecting narrative. Makes a scenario difficult to assess for internal consistency.
Transition and physical scenarios modelled independently. Misrepresents the relationship between transition pace and long-run physical risk.
Scenarios constructed but not connected to portfolio loss estimation. Reduces the exercise to a standalone narrative with no quantitative risk output.
Probability weights applied without disclosed basis. Embeds an undisclosed judgement inside an apparently mechanical calculation.
Recommended Practices¶
- Build each scenario from an explicit narrative paired with its specific quantitative macro variables.
- Pair transition and physical risk scenarios rather than modelling each independently.
- Connect constructed scenarios directly to portfolio-level loss estimation.
- Disclose the basis for any scenario probability weighting explicitly.
Continue Reading¶
Related Pillars¶
Related Technical Guides¶
Related Glossary¶
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Frequently Asked Questions
What is climate scenario analysis?
The practice of constructing multiple, internally consistent narrative and quantitative pathways, such as an orderly transition, a delayed transition, or continued high emissions, against which a financial model's climate exposure is tested, rather than assuming a single future pathway.
How is a climate scenario actually constructed?
From an explicit narrative, the qualitative story of how the transition or physical climate pathway unfolds, paired with the specific quantitative macro variables that narrative implies, carbon price trajectory, temperature pathway, and policy stringency among the most common.
Why should transition and physical risk scenarios be paired rather than modelled independently?
Because an orderly, rapid transition scenario typically implies lower long-run physical risk, while a delayed transition scenario typically implies higher long-run physical risk, and modelling the two risk types independently, without this relationship, misrepresents how they actually co-move across plausible future pathways.
How do constructed scenarios feed into portfolio-level risk quantification?
Directly, providing the specific inputs the entity or portfolio-level loss estimation in climate risk financial modelling runs against, rather than remaining a separate narrative exercise whose outputs are not actually connected to the quantitative risk model.
How should scenario probability weighting be handled?
Disclosed as an explicit assumption in its own right where used, since a probability weight applied to a given scenario reflects a judgement about the relative likelihood of different future pathways, not an objective input, and presenting it without disclosure embeds that judgement invisibly inside what appears to be a mechanical calculation.
References
Related Articles
Climate Finance & Climate Financial Modelling
Climate finance is the mobilisation and allocation of capital toward mitigation, adaptation, and transition activity, and climate financial modelling is the discipline of representing that activity's cash flows, risk, and concessionality in a financial model. This page is the hub for the Knowledge Centre's climate finance content: how sustainable, green, and transition finance are distinct but related capital allocation frames, how a climate investment model differs from a standard project or corporate model in its treatment of concessional capital and additionality, how physical and transition climate risk are quantified at portfolio and entity level, and how carbon markets, climate-sector investment, and institutional governance practice build on these foundations as this domain expands.
Climate Risk Financial Models
Climate risk financial modelling quantifies physical and transition climate risk at entity or portfolio level using a defined scenario framework, distinct from adjusting a single valuation's discount rate or cash flows. This guide covers exposure mapping, scenario-based loss estimation, and how a portfolio-level climate risk model differs in scope and purpose from the single-valuation climate risk adjustment already covered elsewhere in this Knowledge Centre.
Physical Climate Risk Models
Building a physical climate risk model requires translating hazard exposure, whether acute event-driven or chronic gradual change, into a financial loss figure at asset or portfolio level. This guide covers asset-level hazard exposure mapping, the distinct loss estimation methodology appropriate to acute and chronic risk respectively, and how hazard data is translated into a usable financial output.
Transition Risk Models
Building a transition risk model quantifies an entity or portfolio's exposure to the policy, regulatory, and market shifts of decarbonisation, carbon pricing exposure, demand-shift exposure, and stranded asset risk, run against paired transition scenarios. This guide covers how each exposure channel should be quantified and how the resulting risk should be aggregated at portfolio level.
TCFD
TCFD, the Task Force on Climate-related Financial Disclosures, is a widely adopted framework structuring how an entity discloses climate-related risk across four pillars, governance, strategy, risk management, and metrics and targets. It underpins much of current climate risk disclosure practice, including the scenario-based approach applied in portfolio-level climate risk financial modelling.