The title may sound like an attempt at buzzword bingo, but actually covers a key topic: How can you optimise your business strategy in the face of massive uncertainty as the world grapples with climate change and geopolitical uncertainty? We argue that rigorous Scenario Based Financial Planning goes a long way to make a firm resilient.
If there is one thing every business knows, the world does not stay still. Firms can either understand these changes and anticipate the potential changes and grasp the opportunities and mitigate the threats from these potential changes or they can ignore them and be at their mercy.
This forms the basis of strategic planning. Most firms assess in detail their market share and competitor analysis and their medium term economic and cost environment. However, firms are only beginning to consider the scale of coordinated global action needed to avoid the worst impacts of climate change when thinking about their business strategies. Following the CBES stress test carried out for UK banks, The Bank of England concluded that climate risk is “a first-order strategic issue”* and noted that climate impacts led to a persistent drag on annual profits of around 10-15%. So this is now understood to be a strategic imperative to any firm that wants to think ahead, but how many firms could really answer the following questions:
- Which of our businesses have the best risk and reward ratio under different climate outcomes or de-globalisation?
- If I invest $500m in this business, under what scenarios would this not deliver a return?
- What do we need to do now to ensure we don’t suffer from adverse selection in our lending decisions as climate regulations develop?
- How will our climate and ESG metrics and scores look in 5 or 10 years time under our current strategy? What actions would be needed to meet our targets?
Firms are only beginning to look at the wide-ranging impacts of climate change on their business and to take into account their own impact and the importance of reputation with stakeholders. Some climate and ESG related targets may be introduced, but this does not really help optimise a firm’s strategy for the climate uncertainties that lie ahead.
- Will global temperatures increase by 1.5% or 3% by 2050? And how would rise in global temperatures really impact my business?
- How will trade flows develop over the next 15 years?
- How important will fossil fuels be by 2040? How will this be impacted by increased focus on energy security?
- How will energy costs evolve as governments take action to reduce carbon emissions or will only limited action be taken to curb climate change?
- Alternatively, what would be the implications if sustainable energy becomes cheap to generate and store?
Similarly, changing expectations of investors and customers and the regulatory environment will develop over time.
- What will regulations and stakeholder expectations look like in 2035? Will the firm be strategically exposed?
- How will loan pricing be impacted? What sectors will expand and which will contract?
- How will Climate ratings / ESG scores (or their replacement) impact the firm’s own funding costs?
- What will our firm’s ESG score be in 5 years? Will this be acceptable to our customers?
No-one knows the answers to these questions. But they are no less important as a result of this.
So how can management make sense of all of this? The answer partly lies in climate models, which many firms are beginning to use. Also, climate scenarios which are beginning to be used in the context of climate stress tests can give an indication of potential physical and transitional impacts of climate change.
However, they are yet to be brought centre stage within strategic planning and it is key to understand the range of uncertainty embedded within them. As economists know, predictions are difficult, particularly about the future, but with the right tools you can still ensure your firm is resilient to a range of outcomes.
Basinghall Analytics scenario-based financial planning solution is designed to answer some of the above questions and support firms in becoming more resilient to adverse impacts of climate change. In particular, the solution’s capability includes:
- Assessing multiple scenarios (including upside as well as downside) that reflect uncertainty of the climate models;
- Quantification of the impact of climate variables on your business and risk;
- Computation of metrics similar to a forward-looking climate risk rating;
- Integration into a complete firmwide scenario analysis infrastructure capable of generating granular outputs;
- Incorporation of the impact of strategic decisions and project over long horizons.
- Ability to track progress and re-plan as events unfold and regulations and expectations develop.
One of the key themes for feedback from the Bank of England climate stress test was the need for some firms “to consider more deeply how they would respond strategically to different scenarios, including thinking through the implications of different paths for climate policy.”*
The combination of high-quality climate models and leading-edge scenarios analysis provided by our solution gives a powerful means of supporting you in your journey to strategic resilience.
* Climate capital − speech by Sam Woods, Bank of England on 24 May 2022