DP17944 A Bespoke, probabilistic approach to climate scenario analysis
We develop a new approach to designing climate scenarios and assessing the impact of physical and transition climate risks on companies and markets that is better tailored for financial and investment decision making. Our main innovations are that we: (i) allow for more plausible policy variation across sectors and regions to construct ‘bespoke’ scenarios that are more realistic than typical ‘off-the-shelf’ reference scenarios, (ii) develop a baseline scenario benchmarked against what is priced into the market to better identify potential asset price misalignments, (iii) assign probabilities to scenarios and aggregate them to analyse how the long-term fair valuation of asset prices relates to a probability-weighted mean outcome. Our main results indicate that while the transition to a lower-carbon global economy is highly likely to continue, the world is unlikely to converge on a Paris-aligned trajectory - our probability-weighted mean scenario points to a 2.3°C warming by 2100. While transition effects on corporate equities and bonds at the index level is modest, we find large variations at the asset level and within sectors, implying that climate risks and opportunities are largely a micro investing phenomenon. We also find that the choice of scenario as well as our regional, sectoral and technological choices can greatly affect asset and sector valuation. Lastly, incorporating and assessing the credibility of companies’ transition plans into the model can significantly modify their valuation. We believe that our probabilistic bespoke climate scenario approach provides unique insights for capital allocation by constructing a realistic assessment of scenario pathways. Different users can make different choices depending on their beliefs and objectives, they can dynamically update their assumptions with new information
