Scenario analysis in six charts

The report explains aspects of scenario analysis and its usefulness to investors. Six charts illustrate the purpose of scenario analysis as a tool to deal with uncertainty, steps involved in bottom-up modelling of climate risks, assessing financial risks based on scenarios, benchmarking for stock picking, integrating scenario analysis into company valuation, and determining whether to use discounted cash flow or multiple-based models.

Why assess “transition” risks?

The report argues that assessing “transition” risks is critical for investors considering the impact of climate change and energy transition on business. Investors are encouraged to assess transition risks since the transformation towards reducing carbon emissions in many sectors may cause business transition risks. The authors suggest that this risk is significant for both financial markets and companies since it may lead to the mispricing of climate-related risks. It is recommended that investors have an understanding of different risks faced by companies in the current climate, in line with the development of the electric utility sector.

Is it different from fundamental analysis?

The report highlights that the risks and opportunities beyond 2-5 years are often not quantified. It suggests utilising scenario analysis as a solution to complement short-term forecasts with insights that might then be integrated into valuation models. It also emphasises the need for new tools and frameworks.

How to perform scenario analysis?

The authors suggest that scenario analysis involves selecting the appropriate methodology and performance parameters to anticipate the impact of climate and energy transition on financials. Six steps  of the financial risk modelling are; identifying the key drivers for scenarios, building a meaningful asset/product portfolio database, analysing companies’ adaptive capacity, analysing companies’ asset base/product portfolios, analysing markets to calculate prices and revenues, and calculating the financial impacts for assets and companies.

How to integrate scenario analysis into company valuations?

The report discusses the possible integration of scenario analysis and company valuations and how they work together to incorporate transition risks in the valuation process. It recommends that discounted cash flow models are being increasingly applied to assess whether a company is sustainable under different scenarios. The report also provides a step-by-step process to integrate scenario analysis into a company valuation process.

Key conclusions

The authors conclude that scenario analysis, although subject to uncertainty, is a useful tool to assess transition risks in the current financial market and suggests that there is a growing demand from investors for better transition risk analysis in companies. The authors also proposed that the future development of scenario analysis can provide businesses with robust and informative insights to evaluate and address transition-related risks and investors to make informed economic decisions.