The use of climate-related scenarios is a critical tool to quantify the impact of these hypothetical events on the value of investments. Yet, the practical application of climate scenarios can challenge even experienced finance practitioners.

A new report from the MSCI Sustainability Institute aims to help practitioners make the most of climate scenario analysis by classifying the types of scenarios and suggesting how each – alone or together – can support progressive levels of scenario integration.

“The report espouses a holistic approach to climate scenario analysis designed to improve financial decision-making and infuse planning with resilience,” write co-authors James Edwards, executive director for climate risk research at MSCI Research and an Institute fellow for the climate scenario landscape, Nathan Faigle of MSCI Research, and Wenmin Li, an associate for climate risk with the U.N. Environment Programme’s Finance Initiative (UNEP FI).

The report classifies climate scenarios into four types, based on their complexity and characteristics. In addition, it advocates for adoption of climate scenario analysis across four levels, which start with using fully narrative scenarios to identify key pathways. Implementation continues with quantifying the financial impact of scenarios using quantified or model-driven scenarios, refining the analysis, and integrating the output of climate scenario analysis into decision-making.

“Each type is an important tool for understanding the economic, financial and societal consequences of climate change,” notes David Carlin, former head of risk at the UNEP FI, in a foreword to the report. “With the financial community facing increasingly complex climate challenges, the insights that scenario analysis offers are now more essential than ever.”

The report also considers the use of climate scenarios in specific applications, including internal stress testing for both prudential supervision and regulation, and uses of scenario analysis to fulfill disclosure obligations. It further considers scenario analysis in the context of stress testing for investment activities, as well as for risk management and engagement.

The report complements work by the Institute and MSCI’s Climate Risk Center to develop a climate scenario informed by market participants’ consensus expectations on how the risks of a changing climate and the transition to a low- carbon economy could impact their investments.

“Regardless how they approach the task, scenario analysis, if integrated into investment workflows, can enhance practitioners’ ability to manage climate risks and capitalize on opportunities,” the authors write.