Climate scenario anxiety highlights legal risk

Is climate scenario anxiety on the rise? There is at least nervousness, evident already this year in guidance on climate scenario analysis from the Network for Greening the Financial System (NGFS), with over a hundred central banks and supervisors as members, and the Basel Committee on Banking Supervision’s decision to address the same topic.

To most, climate scenario analysis lies at the technical end of the spectrum of technical. However, it gets deep into the plumbing of decision-making across the business, financial and policy worlds, influencing all sorts of real-world outcomes. So, if current concerns with its use are well-grounded, there are significant implications, including for legal risk.

A climate scenario describes a plausible future state under conditions of uncertainty based on assumptions about the trajectory of global warming and its possible impacts. Scenario analysis involves assessing alternative scenarios to reach a view on the implications of climate change for a given organisation and deciding what to do. It can help in navigating the uncertain range of social, political, economic and environmental avenues that could emerge as climate change intensifies.

Practice remains nascent but climate scenario analysis is now widespread, partly due to recommendations like those of the Taskforce on Climate Related Financial Disclosures (TCFD), now taken over by the International Sustainability Standards Board (ISSB).

The ISSB’s standards require relevant entities to disclose sufficient information for users of general purpose financial reports to understand their climate resilience. To assess climate resilience, entities are to use climate-related scenario analysis commensurate with their circumstances. For the ISSB, ‘climate resilience’ is an entity’s capacity to adjust to climate-related changes or uncertainties, including addressing risks and opportunities. For some entities, standards like this are or soon will be set by law. In other cases, they create good practice expectations that could also have a legal edge.

However, the use of climate scenario analysis reaches far beyond ISSB disclosure, for example, in business planning and pension fund management. It is clearly important, therefore, to use reliable scenarios and to do so well. And that is where the concerns emerge.

Reports from various bodies and academics in recent months have questioned how effectively climate scenarios are being used and their accuracy. Two in particular, The Emperor’s New Climate Scenarios (from the UK’s Institute and Faculty of Actuaries and Exeter University) and Loading the DICE against pension funds (from Carbon Tracker) have flagged a material disconnect between economic outcomes predicted by commonly used scenarios created by economists and the views of the scientific community. Among other things, outcomes predicted by the latter are substantially less benign. The NGFS has advanced its own climate scenarios, and January’s ‘explanatory note’ addresses some of these issues.

A court’s view on what legal duties require is often influenced by respected bodies of professional opinion. The UK’s Institute and Faculty of Actuaries regulates and represents over 32,000 members worldwide – a respected professional body, one would have thought, when it comes to measuring the financial impact of future events and managing risk. And now there is the NFGS guidance. So, there may be legal as well as commercial, financial and policy risks if concerns around climate scenarios have substance: steps not taken that should have been, others taken that shouldn’t and inaccurate disclosure to investors, beneficiaries and markets. Add to this the systemic risks if market operators cluster around common scenarios and it is indeed an anxiety-inducing mix.

In response, what sort of questions do market operators need to ask themselves and their advisors? These would be a good start.

First, are we using climate scenario analysis to help in achieving our goals and discharging associated legal duties?  If not, should we and what sort is best given our circumstances and needs? What timeframes and sources of risk and opportunity should it cover? What is the role of narrative and numbers, qualitative and quantitative assessments?

Second, if we are using scenario analysis, are we doing so well? What level of reliance should we place on it? Do we sufficiently understand the shortcomings and how can we correct for these in our decision-making?

Third, are the climate scenarios we’ve been using like those highlighted in recent reports? Does that make them unreliable for current purposes? Can they be supplemented or adapted?

Finally, if our current scenarios have shortcomings, do decisions based on them need revisiting or disclosures need correction?

As things stand, everyone is still feeling their way. Courts and regulators can be expected to get that, for now at least. Nonetheless, entities will ultimately need to ensure that time spent in model worlds is helping them live more effectively in the real world.