An MIT white paper released today outlines a series of recommendations on how companies, particularly those in the oil and gas industry, can use scenario analysis to effectively disclose risks and opportunities they face as a result of global climate change.
The report, “Climate-Related Financial Disclosure Disclosures: The Use of Scenarios,” was organized by the Office of the Vice President for Research and drafted by a team of MIT faculty and staff members. It builds on insights gained from a workshop held at MIT last year, which included representatives from oil and gas companies, credit rating agencies, investment firms, and nongovernmental organizations, along with academics and other entities engaged in the production of global climate scenarios.
“This report, and the workshop it grew out of, are part of MIT’s ongoing efforts under our Plan for Action on Climate Change,” says Vice President for Research Maria T. Zuber. “A key element of the plan is a strategy of engaging with a wide variety of sectors to accelerate the world’s transition away from carbon emitting energy sources.”
Financial disclosures that include an examination of risk factors that could impact a company’s operations, facilities, and financial performance are an essential tool to provide guidance to potential investors and lenders, credit rating agencies, and insurers. For these disclosures to be useful, however, they must be prepared using comparable methods and consistent approaches.
In 2017, the Task Force on Climate-related Financial Disclosures (TCFD), established by the G20 Financial Stability Board, provided a guiding framework and set of recommendations to promote that kind of consistency. However, the use of scenario analysis to describe the resilience of a company’s strategy, as recommended by the TCFD, still represents a significant challenge for companies. MIT, with its extensive experience in analysis of climate futures, saw this as an opportunity to shed some light on the task.
“The point was to engage with industry to help all of the different stakeholders get on the same page about the scenarios they use,” says Erik Landry SM ’18, research associate in the Office of the Vice President for Research and lead author of the report. “Once a common understanding is reached, then at least we are all working on the same problem.” Landry is also a recent graduate of MIT’s Technology and Policy Program.
The report aims to advance the state of scenario-based disclosures of climate-related risks and opportunities by promoting a better understanding of the underlying scenarios. It is meant to help oil and gas companies produce more useful scenario-based disclosures, help the financial community better evaluate such disclosures, and enable a dialogue that would help scenario producers make their scenarios more relevant to company-level climate-related risk assessment.
Henry Jacoby, the William F. Pounds Professor of Management, Emeritus, in the MIT Sloan School of Management and a member of the MIT working group, says, “Most climate scenarios were developed to study the implications of specific policies or technological developments, not to assess near-term financial risks in a particular industry,” so the report tries to outline ways such scenarios can be applied usefully to this new task. “We’re trying to tweak the tools to fit the purposes we’re trying to use them for,” he adds. In this case, a major aim is to help financial decision-makers make more informed decisions about where best to allocate resources, potentially in ways aligned with a low-carbon transition.
Many different groups produce such scenarios, the report points out. One widely used set of scenarios is that issued annually by the International Energy Agency. But several other organizations, including the Integrated Assessment Modeling Consortium, the International Renewable Energy Agency, and the Organization for Economic Cooperation and Development, also produce scenarios, each one taking a somewhat different approach. The producers of these climate scenarios “all differ in their modeling methodologies, and one or another may be more relevant to some sectors,” Landry says. “It is important for financial decision-makers to be aware of the underlying assumptions being made about the future.”
Arguably, the strength of using scenarios lies in their range of possible futures they can explore, from “business as usual” scenarios to those in which global temperature rise is limited to 2 degrees Celsius, and beyond. Scenarios involve various assumptions about technology and policy. Some assumptions that go into these scenarios are relatively easy to quantify, such as whether or not a carbon price is implemented, and if so how much it is and how it increases over time. Other factors have greater inherent uncertainties, such as the expected rate of improvement in energy production and storage technologies, the development and scalability of carbon capture and sequestration, or social factors such as how quickly people change their energy-related choices.
One recommendation the report makes is for oil and gas companies to compare their own scenarios to “reference scenarios,” or credible scenarios that are commonly used and understood by many stakeholders. While companies may want to include their own specific scenarios based on the unique characteristics of their own facilities and supply chains, making clear exactly how their scenarios differ from a reference case enables investors to assess each company by its own merits, while also retaining a level of comparability between companies. “Insofar as companies disclose clearly and transparently what scenarios they use and what assumptions go into them, they can let investors to do their jobs and see how they compare,” Landry says.
It also calls for companies to be complete in their descriptions of how their strategies are resilient in the face of a changing climate and a low carbon transition. This includes addressing both where the company’s vulnerabilities lie and their degree of preparedness. For audiences evaluating such descriptions, it’s important to “be wary of general claims of resilience that are not visibly grounded in clear, consistent, and transparent use of scenarios,” Landry says.
While this report focuses on the climate-related disclosures by the oil and gas industry, the authors believe that the principles it outlines should also be very applicable to many other industries such as manufacturing, commercial transportation, or agriculture. With more useful disclosures, financial decision-makers can make choices that not only promote their own interests, but also encourage the advancement of more sustainable business models.
The report was produced by MIT’s Working Group on Climate-Related Scenarios, which in addition to Landry and Jacoby included Louis Carranza and Sergey Paltsev of the MIT Energy Initiative, James Gomes of the Office of the Vice President for Research, and Donald Lessard and Bethany Patten of the MIT Sloan School of Management.