Learning Outcomes

By the end of this lesson, learners should be able to:

• Explain the purpose of climate scenario analysis.
• Understand how scenario analysis supports climate-related decision-making.
• Differentiate between the NGFS climate scenarios: Orderly, Disorderly, and Hot House World.
• Describe the process of conducting climate stress tests.
• Interpret climate stress test results to improve organizational resilience and strategic planning.

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Introduction

Climate change presents organizations with significant uncertainty because its future impacts depend on many interacting factors, including government policies, technological innovation, economic development, population growth, and society’s response to greenhouse gas emissions. Since it is impossible to predict the future with complete certainty, organizations need tools that allow them to evaluate how different climate futures could affect their operations, investments, and long-term performance.

One of the most widely used tools for managing this uncertainty is climate scenario analysis. Rather than attempting to forecast exactly what will happen, scenario analysis explores several plausible future pathways and examines how each could influence an organization’s risks and opportunities. It enables businesses, financial institutions, and governments to identify vulnerabilities before they become critical problems and to develop strategies that remain effective under different future conditions.

Closely related to scenario analysis is climate stress testing, which examines how well an organization can withstand severe but plausible climate-related shocks. Together, these approaches strengthen risk management, improve strategic planning, and enhance organizational resilience.

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1. Purpose and Application of Climate Scenario Analysis

Climate scenario analysis is a strategic planning tool used to evaluate how different climate futures may affect an organization. Instead of relying solely on historical data, it considers a range of possible future conditions, allowing decision-makers to prepare for uncertainty.

Climate scenario analysis recognizes that climate change is influenced by numerous variables, including international climate policies, technological advancements, economic growth, consumer behavior, and environmental changes. Since these factors evolve over time, organizations need flexible planning approaches that account for multiple possible outcomes.

Scenario analysis does not attempt to predict which future will occur. Instead, it asks questions such as:

• What happens if governments rapidly strengthen climate policies?
• How would the business perform if global temperatures continue to rise significantly?
• What would happen if renewable energy becomes much cheaper than fossil fuels?
• How resilient is the organization under different climate conditions?

By exploring these questions, organizations gain a deeper understanding of potential risks and opportunities.

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Why Scenario Analysis is Important

Traditional risk management often relies on historical trends to estimate future risks. However, climate change is creating conditions that have few historical precedents, making past data less reliable for future planning.

Scenario analysis helps organizations prepare for these uncertainties by:

• Improving long-term strategic planning.
• Identifying climate-related financial risks.
• Supporting investment and capital allocation decisions.
• Evaluating the resilience of business models.
• Informing climate adaptation and mitigation strategies.
• Supporting climate-related financial disclosures.

Financial institutions, insurers, regulators, investors, and multinational corporations increasingly use scenario analysis as part of enterprise risk management because it provides a structured approach to evaluating uncertainty.

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Applications Across Different Sectors

Climate scenario analysis is used across many industries.

Although the specific applications differ, the overall objective remains the same: improving resilience in an uncertain climate future.

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2. The Scenario Analysis Process

Climate scenario analysis follows a structured process that enables organizations to evaluate climate-related risks systematically.

Step 1: Define the Objective

Organizations first determine why the analysis is being conducted.

Common objectives include:

• Assessing investment risks.
• Evaluating business resilience.
• Supporting strategic planning.
• Meeting regulatory disclosure requirements.
• Informing capital allocation decisions.

Clearly defining the objective ensures that the analysis addresses relevant business questions.

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Step 2: Identify Climate Risk Drivers

Organizations identify the physical and transition risks that could affect their operations.

Examples include:

• Rising temperatures.
• Flooding.
• Carbon pricing.
• Renewable energy adoption.
• Technological innovation.
• Changing consumer preferences.
• Regulatory reforms.

Understanding these drivers helps identify which risks should be included in the analysis.

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Step 3: Select Appropriate Scenarios

Organizations choose one or more climate scenarios that represent different possible futures.

Scenarios may differ based on:

• Global temperature increases.
• Climate policy ambition.
• Economic development.
• Technological progress.
• Energy transition pathways.

Using multiple scenarios provides a broader understanding of uncertainty than relying on a single projection.

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Step 4: Assess Financial and Operational Impacts

Organizations estimate how each scenario could influence:

• Revenue.
• Operating costs.
• Asset values.
• Supply chains.
• Infrastructure.
• Investments.
• Customer demand.

This assessment may involve quantitative models, qualitative analysis, or a combination of both.

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Step 5: Develop Response Strategies

Based on the findings, organizations identify actions to strengthen resilience.

Possible responses include:

• Investing in resilient infrastructure.
• Diversifying supply chains.
• Reducing greenhouse gas emissions.
• Improving energy efficiency.
• Updating investment portfolios.
• Revising corporate strategy.

Scenario analysis therefore supports proactive rather than reactive decision-making.

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3. NGFS Climate Scenarios

The Network for Greening the Financial System (NGFS) has developed internationally recognized climate scenarios that help financial institutions, businesses, and regulators assess climate-related risks.

The NGFS scenarios combine climate science with economic modeling to examine how different policy responses and levels of global warming may affect economies and financial systems.

The three broad scenarios commonly used are:

• Orderly Transition
• Disorderly Transition
• Hot House World

Each scenario reflects a different combination of climate policy ambition, technological progress, and resulting physical and transition risks.

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Orderly Transition

An Orderly Transition assumes that governments, businesses, and society begin taking early, coordinated action to reduce greenhouse gas emissions.

Climate policies are introduced gradually, allowing organizations sufficient time to adapt. Investments in renewable energy, clean technologies, and sustainable infrastructure occur steadily, reducing long-term physical climate risks.

Although businesses incur transition costs, these costs are generally manageable because the transition occurs in a predictable manner.

Characteristics

• Early climate policy implementation.
• Stable regulatory environment.
• Gradual technological transformation.
• Lower long-term physical climate risks.
• Predictable economic adjustment.

Organizations operating under this scenario have greater opportunities to plan investments and adapt their business models efficiently.

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Disorderly Transition

A Disorderly Transition assumes that climate action is delayed for several years before governments implement aggressive policies to meet climate targets.

The delayed response results in rapid regulatory changes, higher carbon prices, accelerated technological disruption, and significant market adjustments.

Because organizations have less time to adapt, transition risks become much higher.

Examples include:

• Sudden increases in carbon taxes.
• Rapid retirement of fossil fuel assets.
• Sharp declines in demand for carbon-intensive products.
• Increased investment uncertainty.

Although long-term climate goals may still be achieved, the economic transition becomes more disruptive.

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Hot House World

A Hot House World assumes that climate policies remain weak and global greenhouse gas emissions continue increasing.

Limited climate action results in significantly higher global temperatures, increasing the severity and frequency of physical climate risks.

Under this scenario, organizations experience increasing exposure to:

• Heatwaves.
• Floods.
• Droughts.
• Wildfires.
• Sea-level rise.
• Food insecurity.
• Water scarcity.

Transition risks are relatively lower because fewer climate policies are introduced. However, physical risks become extremely severe, resulting in significant economic losses and reduced long-term resilience.

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Comparison of NGFS Climate Scenarios

Each scenario illustrates that different policy choices create different combinations of risks. Organizations therefore need strategies that remain resilient across multiple possible futures.

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4. Climate Stress Testing

Climate stress testing is a risk assessment technique used to evaluate how an organization performs under severe but plausible climate-related events.

Whereas scenario analysis explores a range of possible futures, stress testing focuses on extreme situations that could significantly affect organizational performance.

Stress tests help answer questions such as:

• Could the organization survive a major climate shock?
• Which assets are most vulnerable?
• How would profits be affected?
• Are current risk controls sufficient?

Stress testing is widely used by banks, insurers, regulators, and large corporations to assess financial resilience.

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Conducting Climate Stress Tests

Climate stress testing typically follows several stages.

Identify Critical Assets and Activities

Organizations first determine which operations, facilities, investments, and supply chains are most important to business continuity.

Critical assets often include:

• Manufacturing facilities.
• Distribution centers.
• Energy infrastructure.
• Loan portfolios.
• Investment portfolios.
• Information technology systems.

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Define Severe Climate Events

Organizations then develop severe but plausible climate events to test resilience.

Examples include:

• A major coastal flood.
• Multi-year drought.
• Prolonged heatwave.
• Rapid introduction of high carbon taxes.
• Collapse in fossil fuel demand.
• Severe supply chain disruption.

These scenarios should be challenging yet realistic.

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Estimate Financial Impacts

Organizations evaluate how these events affect financial performance.

Possible impacts include:

• Property damage.
• Reduced revenues.
• Increased operating costs.
• Higher insurance premiums.
• Asset impairment.
• Credit losses.
• Supply chain interruptions.

Quantifying these impacts enables organizations to understand potential financial exposure.

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Evaluate Existing Controls

Organizations assess whether current risk management measures are sufficient.

Questions include:

• Are emergency response plans adequate?
• Is insurance coverage sufficient?
• Are suppliers diversified?
• Is infrastructure climate resilient?
• Are contingency plans effective?

Identifying weaknesses helps prioritize future improvements.

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5. Interpreting Climate Stress Test Results

Conducting a stress test is only the first step. Organizations must also interpret the findings and translate them into meaningful actions.

Stress test results often identify:

• High-risk assets.
• Financial vulnerabilities.
• Operational weaknesses.
• Supply chain dependencies.
• Areas requiring additional investment.
• Strategic priorities for adaptation.

Management then uses these insights to strengthen resilience through improved governance, infrastructure investments, business continuity planning, and climate adaptation initiatives.

Stress testing is therefore an ongoing process rather than a one-time exercise. As climate science, regulations, and technologies continue to evolve, organizations should regularly update their analyses to reflect changing conditions.

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Relationship Between Scenario Analysis and Stress Testing

Although the two approaches are closely related, they serve different purposes.

Organizations often use both approaches together to gain a comprehensive understanding of climate-related risks.

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Key Takeaways

Climate scenario analysis helps organizations evaluate how different future climate pathways could affect their operations, financial performance, and long-term strategy. Rather than predicting a single future, it explores multiple plausible outcomes to support informed decision-making under uncertainty.

Scenario analysis follows a structured process that includes defining objectives, identifying climate risk drivers, selecting appropriate scenarios, assessing impacts, and developing strategic responses. It is widely used in banking, insurance, energy, manufacturing, and government planning.

The NGFS climate scenarios provide standardized pathways for assessing climate risks. The Orderly Transition assumes early and coordinated climate action with manageable transition costs, the Disorderly Transition reflects delayed but abrupt policy changes leading to higher transition risks, and the Hot House World assumes limited climate action, resulting in severe physical climate impacts.

Climate stress testing complements scenario analysis by examining how organizations perform under severe but plausible climate-related events. It helps identify vulnerabilities, evaluate financial resilience, and strengthen preparedness through targeted adaptation and risk management measures.

Together, scenario analysis and climate stress testing enable organizations to make more resilient strategic decisions, improve governance, and prepare for the uncertainties associated with climate change.