In an increasingly complex and uncertain world, investment decision making is a challenging task. Climate change is adding an additional risk factor because of its potential impact on every step of the investment decision process, complicating matters further. In recent years, climate risk analyses were typically performed by sustainability teams, remaining quite disconnected from the work of traditional investment and risk teams. However, this is starting to change with results and insights from climate risk analysis and from traditional and investment risk analysis being combined and integrated to drive investment decision making.
This paper starts by discussing how a scenario analysis approach has become central for incorporating climate risk into investment decision making and then goes on to discuss some of the challenges that are presented from integrating climate risk analysis and traditional investment risk analysis.
It discusses how using probabilities in climate scenarios is problematic, due to the lack of empirical guidance and the fundamental or radical uncertainty associated with climate risk. It then highlights questions about consistency when combining traditional risk and return analyses with insights from deterministic climate scenario analyses. It also looks at risk and return assumptions and how, in the case of climate risk, the absence of an empirical basis becomes a limiting factor. It concludes by looking at the different data sets available and how the result of any sensible modeling exercise should always be interpreted in the light of the assumptions that were formulated at the outset.