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Scenario analysis: an important tool for understanding the potential impact of climate change

“If you look at property in a given geographical region, how will an increase in the number of floods or a rise in the sea level or a lower population density affect the value of offices, factories and residences? A scenario-based approach allows us to view a complex problem in terms of its concrete impact, such as the effects of climate change on property values.”

The above example comes from Luca Taschini, Reader at the University of Edinburgh Business School and an Associate Professorial Research Fellow at the LSE’s Grantham Research Institute on Climate Change and the Environment. As an expert in carbon pricing, Taschini has published a series of academic articles on carbon markets, a key policy tool for curbing CO2 emissions. More recently, he has been studying how changes in climate affect economic outcomes and financial markets. Both these aspects are discussed below.

Policies for tackling carbon emissions

Taschini: ‘As an economist, I have focused on policies that governments can implement to reduce carbon emissions. Basically, there are two alternatives. The first involves taxing CO2 emissions, which means that businesses pay a fixed price for every tonne of carbon they emit. This leads to variations in aggregate levels of emissions. The second approach involves fixing the total quantity of CO2 emissions rather than the price, and distributing property rights (‘permits’ or ‘allowances’) associated with this total quantity, or ‘cap’. The prices of these permits fluctuate reflecting supply and demand balance. This is known as the principle of cap-and-trade.’ Taschini explains that the latter approach is based on a theory developed by the British economist Ronald Coase in the 1960s. He came up with the idea of creating artificial property rights in markets in which there are no clear ownership rights. When the Kyoto Protocol entered into force in 1997, the market mechanism of trading in artificial property rights was applied to CO2 emissions in EU member states and various other countries.

Taschini explains that, under a cap-and-trade system, governments distribute CO2 emission allowances generally by a mix of auctions and free allocation. Regulated firms then trade the allowances during a specified compliance period, after which they are surrendered to the government. Firms with relatively low abatement costs (i.e. the cost of reducing environmental negatives such as pollution) sell their allowances in secondary markets to firms with relatively high abatement costs so that, overall, CO2 emissions are reduced at the lowest possible cost.

The European cap-and-trade system

The EU launched its Emission Trading System in 2005. At the outset, the focus was on industries with high carbon emission levels, such as construction, energy, paper and ceramics. In order for the system to work, it had to be supported by business, and it had to protect European industries against the potential for competitive distortions caused by leakage, that is, incentives for emissions-generating activities to move outside the EU. To this end, emission allowances were given to businesses at a level representing a fraction of their historical CO2 emission levels. So as not to excessively damage their competitive position vis-à-vis their global competitors – who did not have to pay for their carbon emissions – additional emission allowances were issued for free.

The number of free emission allowances has gradually been reduced since 2013. Today, most CO2 emission allowances are sold in fortnightly auctions, and the annual emission cap has been reduced by a small percentage each year. The primary goal is to reduce carbon emissions by 43% by 2030 compared with 2005. Taschini: ‘Discussions are currently ongoing about whether the European Union can levy a carbon tax on imported products, so as to create a more level playing field. That would have been unthinkable ten years ago, because there was no way of placing a figure on carbon emissions for individual products. Today, however, we are much better able to measure the carbon content of imported products such as cement and steel.’

Managing the financial risks of climate change

The market for emission allowances is an excellent example of how an academic theory can be developed into a practical policy that can help change the world. But that isn’t enough, Taschini argues, in the face of climate-related financial risks. These are ever more prominent and their effective management is a top priority for investors and regulators. On the one hand, investors are asking businesses to identify and mitigate their exposure to climate change. On the other hand, regulatory authorities expect financial organisations to measure, quantify and report their risks emanating from the changing climate so that, ultimately, they are more resilient.

Scenario analysis: a tool for understanding potential impacts

Taschini stresses that the first step in mitigating these risks is to think in terms of scenarios. While scenarios are not the same as projections, detailed scenario planning is an excellent way of concretising the effects of climate change. Although advances in data and computing have triggered rapid progress in our ability to measure how climatic conditions affect the economy, we still only have a fairly limited understanding of how projected changes in the climate are likely to alter social and economic outcomes. Scenario analysis is an important tool for understanding these potential impacts. It is all about making a “what if?” analysis of different potential projections of the future. For example, scenarios can be used to express the range of effects that different temperature changes could have on extreme weather events, rises in the sea level, agricultural output, public health, population density and so on.

Refine each scenario

The next step after this type of macro-level exercise is to refine each scenario at a micro level, Taschini says. ‘As a pension fund, for example, I don’t want necessarily to overcomplicate my life, so I would project scenarios at a country or regional level and see what they mean for different regions and sectors – and for my investment portfolio. For example, if you look at property in a given geographical region, how will an increase in the number of floods or a lower population density affect the value of offices, factories and residences? This approach allows us to view a complex problem in terms of its concrete impact, such as the effects of climate change on property values.’

Taschini claims that some sectors, which are set to undergo major changes as a result of the climate transition, may face sudden price changes and changes in consumer behaviour: ‘Consumers may start to generate more of their own electricity. The popularity of electric cars is on the rise, coal-burning power plants are more likely to shut down, and so on. All these trends are interconnected. Institutional investors such as pension funds will have to start using scenario planning in the future when thinking about the long-term consequences for the risks and returns of their investments.’

Institutional investors such as pension funds will have to start using scenario planning in the future when thinking about the long-term consequences for the risks and returns of their investments.

Whatever happens, he expects climate change to have a big impact on the global economy in the years to come: ‘What exactly that impact will be, is hard to predict. First of all, we will have to deal with the physical effects of climate change, such as storms, droughts and flooding. Climate change also triggers other changes, such as new government policies, new technologies, and changes in consumer behaviour. All these in turn affect each other, thus creating an extremely complex system that is impossible to predict with a high degree of reliability.’

He is not particularly optimistic about the pace at which change is taking place: ‘My gut feeling is that we are very much behind what we need to do, partly because we don’t really have the means to precisely measure the distance between the impact of current and future changes in climate and these future scenarios. An added problem is that some of these scenarios are difficult to translate into material information that you can feed into decision-making and risk analysis. The government and the private sector are working hard to try to bridge this gap. After all, if you can’t measure the risk, you can’t manage it.’