How climate scenario analysis can help energy companies mitigate financial risk exposure

Climate change brings with it a compendium of previously unconsidered risks that will impact an energy company’s financial and physical performance. Identifying these climate risks and making plans to mitigate them can help energy companies and policymakers manage the impacts of climate change.

What is not certain is the form these risks may take and how markets, technology, and consumer behavior may evolve. So, what can be done to identify and address risks now? Companies can gain invaluable knowledge about their risk exposure through market-based scenarios that take into consideration the uncertainty around future climate impacts. With increasing focus by stakeholders on understanding climate risk exposure, it is critical to identify and begin to take measures to mitigate financial risk exposure now using realistic scenarios at a level detailed enough to assess the risk exposure of a company—the type of detail not available in a global transition scenario.

Based on ICF’s work with North American oil and natural gas companies, we present multiple scenarios for the impact of climate change on future prices, demand, and supply. We also offer recommendations to help oil and natural gas companies mitigate their physical and financial risks while building the confidence of investors, customers, policymakers, and regulators.

Climate-related financial disclosures are here to stay

Scenario analysis (the process of forecasting value given changes in parameters such as policies, taxes, technology, temperatures, precipitation, or commodity prices) is one of the best tools for a business and its investors to identify its financial exposure to climate risk factors. It can also be used to identify strategies to mitigate that risk exposure, as well as to transparently communicate those impacts.

In recognition of this, the International Sustainability Standards Board (ISSB), established by the International Financial Reporting Standards (IFRS) Foundation, published its first standards in June 2023: IFRS S1 and S2. These standards are based on and replace the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and were endorsed by the International Organization of Securities Commissions (IOSCO), which includes regulators of 95% of the world’s securities markets including European Union and U.S. Securities and Exchange Commission (SEC). They mandate that companies in the energy sector conduct climate-related scenario analyses to address the uncertainty associated with climate change, and to enhance flexibility and resiliency of companies given the large uncertainty.

The recommendations of the TCFD and, beginning in 2024, the ISSB, have been voluntary thus far but are quickly gaining traction with regulatory agencies. As of the beginning of 2023, certain ISSB-aligned climate disclosures became mandatory throughout the European Union and United Kingdom, and U.S. and Canadian regulators have proposed similar disclosures for their countries. Likewise, the number of companies that either publicly support or report in line with ISSB guidelines has grown quickly, from around 2,600 in 2021 to over 4,000 as of 2022—and this trend is expected to continue.

Scenario analysis in the energy sector

For an energy company to effectively consider climate risk, the ISSB recommends a company “determine an approach to climate-related scenario analysis that enables it to consider all reasonable and supportable information” including possibly incorporating “multiple carbon price pathways associated with a given outcome (for example, a 1.5 degree Celsius outcome).”

This type of scenario analysis often involves examining a company’s expected performance under a variety of commodity prices, energy demand, and climate futures. Not surprisingly, one of the sectors receiving the most scrutiny from investors, regulators, and the public is the energy sector due to its unique climate-related sensitivities. Paradoxically, only 18% of TCFD-supporting energy companies report climate-related scenario analyses—including a 2°C or lower scenario even though this is a key part of the TCFD’s (and now ISSB's) recommendations for demonstrating resiliency (Part C of the TCFD’s Strategy disclosures and paragraph 22 of the IFSR S2 Strategy disclosures). As these types of disclosures become mandatory or sought after by investors, it is imperative that companies prepare to address the implications implied under 2°C, 1.5°C, or net zero emission scenarios to their financial positions.

Analysis of financial risk due to climate uncertainties can provide more benefits than just complying with investors’ requests or regulators’ requirements; it is an effective way to show companies’ proactivity, prudence, and preparedness toward market transitions under a variety of uncertainties regarding climate and energy markets. It also highlights a company’s ability to earn sustainable returns into the future. Energy market transition scenarios, when properly designed, can illustrate opportunities and provide companies and their investors with confidence regarding future financial performance.

What is a 2°C (or less) scenario?

Creating global climate scenarios identifying end of century temperature change is a specialized skill and intensive effort. The International Energy Agency’s (IEA) annual World Energy Outlook (WEO) has emerged as a widely accepted energy-industry standard for this type of analysis. Benchmarking to the IEA scenarios provides transparency and helps create legitimacy in the eyes of investors and regulators who have familiarity with the IEA. As a result, the WEO scenarios have emerged as the energy-industry standard for risk assessment.

The 2022 WEO’s business-as-usual scenario is the Stated Policies Scenario (STEPS)—a scenario that reflects current policy and declining emissions over time—in which global median temperature rises 2.5°C by 2100. The Announced Pledges Scenario (APS), which includes announced commitments that are not backed by policy and limits global median temperature rise to 1.7°C by 2100, indicates that oil and natural gas will continue to play a meaningful role in the global energy mix for the next three decades even under more aggressive greenhouse gas emissions reduction policies; in the WEO APS, oil supplies 17% of the world's primary energy demand in 2050 and natural gas supplies another 15%, down from 29% and 23% in 2021, respectively.

The WEO’s Net Zero Emissions (NZE) by 2050 Scenario is the greatest departure from business-as-usual as it models a pathway to limit global median temperature rise to 1.5°C above pre-industrial levels. In the NZE Scenario, oil supplies only 7% of the world's primary energy demand in 2050 and natural gas supplies 8%. The IEA describes the difference between the NZE Scenario and the APS as the “ambition gap,” because the globally announced pledges are not nearly ambitious enough to keep global average temperature rise below 1.5°C.

In 2030, CO2 emission levels in the APS are around five gigatons (Gt) lower than in the STEPS, but almost nine Gt higher than in the NZE Scenario; therefore, the emissions gap between the APS and the NZE Scenario by 2030 is nearly twice as large as the gap between the STEPS and the APS. This highlights the magnitude of the policy changes needed globally to achieve the emission reductions set forth in the NZE Scenario. The lesson here is that the goal of scenario analysis is not just about analyzing the effect of a scenario on a company but also analyzing the scenario itself.

A closer look at upstream U.S. oil supply and demand

The IEA summarizes the different outlooks for oil in their climate scenarios. In the APS, U.S. oil production increases by 2 mb/d by 2030 from 2021 levels, largely due to increases in tight oil production. Under the same scenario, North American oil exports increase almost as much as in the STEPS, as they reach 7.3 mb/d in 2030 and 7.5 mb/d for 2050. In the IEA’s NZE by 2050 Scenario, global oil demand never recovers to 2019 levels. Global oil demand falls by close to 20 mb/d by 2030 (from 94.5 mb/d in 2021 to 75 mb/d in 2030). Importantly, the IEA describes U.S. tight oil as the only global oil production type that increases in the NZE scenario and writes that “increases in tight oil will be essential to balance demand” through 2030.

In the case of the NZE Scenario specifically, it is important to assess the probability of the scenario in addition to its impacts. While the 2022 WEO NZE Scenario forecasted that oil demand would never return to its 2019 levels, it has instead continued to grow since 2021. One year into the 2022 NZE Scenario forecast, which projected that oil demand would fall by 2.5% each year on average between 2021 and 2030, the August 2023 IEA Oil Market Report expected liquids demand to surpass 2019 demand and reach record levels of 102.2 mb/d in 2023 (2.2 mb/d more than in 2022). The same report expects global oil demand to grow another 1 mb/d in 2024. The growth in global oil and liquids demand in 2022 and 2023 has already accounted for slightly more than half of the growth expected in the IEA STEPS between 2021 and 2030. Additionally, the U.S. EIA August 2023 Short Term Energy Outlook forecasted at least two more years of global liquids demand growth, expecting consumption to increase by 1.8 mb/d in 2023 and by another 1.6 mb/d in 2024.

What does scenario analysis mean for an oil and gas company or utility?

One of the most important impacts to understand in a climate risk scenario is what will happen to energy commodity prices, including oil and natural gas prices. These commodity prices affect not only the potential profitability of energy companies, but also impact the financial performance of large energy consumers. ICF uses deep-rooted analysis to identify commodity price outcomes under a range of demand scenarios—including ones consistent with the IEA WEO’s demand outlook.

ICF’s scenarios are based on our own independent assumptions of market drivers, including production costs and technological development using sector specific detailed modeling tools. The ICF Base Case Scenario, 1.7°C Scenario, and 1.5°C Scenario show the impact of aggressive emissions-reduction policies on oil and natural gas prices. Figure 1 illustrates the forward commodity price trajectories where the oil and natural gas prices in the 1.7°C Scenario and 1.5°C Scenario are on average 36% and 50% lower between 2022 and 2050, respectively, compared to ICF’s Base Case. Climate change brings with it a compendium of previously unconsidered risks that will impact an energy company’s financial and physical performance. Identifying these climate risks and making plans to mitigate them can help energy companies and policymakers manage the impacts of climate change.