IFRS scenario analysis: A key tool for climate risk management

How IFRS S2 and scenario analysis drive climate risk management

The effects of climate change are becoming increasingly evident across industries and regions, making climate risk management a critical priority for businesses. Enter IFRS S2, a global standard developed to guide companies in identifying, assessing, and disclosing climate-related risks and opportunities. IFRS S2 is designed to enhance transparency and consistency, enabling stakeholders to make informed decisions. A centrepiece of IFRS S2 is scenario analysis, a powerful tool for understanding and addressing potential climate risks.

This article explores the role of scenario analysis under IFRS S2, how businesses can implement it effectively, and key compliance considerations.

What is scenario analysis?

Scenario analysis is a strategic planning tool that examines potential future outcomes by exploring different “what if” situations. It helps businesses evaluate how varying climate pathways might affect their operations, financial performance, and strategic goals.

Under IFRS S2, scenario analysis is pivotal. Companies are required to assess climate-related risks and opportunities using at least two plausible scenarios, one of which must reflect a 1.5  °C scenario pathway aligned with global climate goals. Other scenarios may include other pathways, such as a  2°C transition scenario, or a business-as-usual model with minimal climate intervention.

Why is scenario analysis important?

The utility of scenario analysis lies in its ability to:

• Assess resilience: Evaluate an organisation’s capacity to withstand and adapt to physical and transition risks posed by different climate futures.
• Inform strategy: Guide the development of strategies that are robust under diverse climate outcomes.
• Enhance disclosures: Provide stakeholders with forward-looking insights on the organisation’s preparedness for climate-related challenges and opportunities.

Types of scenarios

1. 1.5°C scenario: Aligns with the global objective to limit warming to 1.5°C above pre-industrial levels, requiring swift emissions reductions and a rapid energy transition.
2. 2°C scenario: Represents a less ambitious but still significant pathway, with slower uptake of mitigation measures compared to the 1.5°C scenario.
3. Business-as-usual scenario: Assumes limited climate actions and continued reliance on carbon-intensive operations, leading to higher emission levels and more severe physical risks.

By integrating these scenarios into analysis, companies can identify potential vulnerabilities, seize emerging opportunities, and plan for sustainable growth.

Strategic decision-making and risk mitigation

Scenario analysis enhances decision-making by enabling organisations to:

• Model disruptions caused by extreme weather, regulatory shifts, or market demands.
• Evaluate investment decisions to adopt sustainable practices or technologies.
• Identify operational and financial impacts that need attention, helping minimise risks and leverage future opportunities.

A key part of this process involves understanding the transition risks and physical risks posed by climate change:

Transition risks: These arise from the process of transitioning towards a low-carbon economy. They encompass regulatory and legal risks, reputational risks, market risks, and technology risks. Examples include changes in climate policies and reporting requirements, reduced demand for goods and services deemed to not be environmentally friendly, and the introduction of low-emissions technologies.

Physical risks: These stem from the direct physical impacts of climate change and are typically divided into:

• Acute risks: Short-term, extreme events such as bushfires, cyclones, floods, and heatwaves.
• Chronic risks: Long-term, progressive changes such as rising sea levels, desertification, and changes in average temperature or precipitation patterns.

By accounting for both transition and physical risks, scenario analysis equips businesses with the insights needed to build resilient strategies, prioritize risk mitigation, and adapt to an evolving climate landscape.

Implementing scenario analysis

Step-by-step guide to scenario analysis

1. Identify relevant climate risks and opportunities

Identifying all material climate-related risks and opportunities relevant to the business through processes such as hazard screening, regulatory landscape reviews, and market analysis. This includes a qualitative assessment on how these risks and opportunities may affect different parts of the business (e.g. physical facilities, supply chains, financial performance), forming the foundation for the scenario analysis.

2.Select material time horizons

Define short-, medium-, and long-term time horizons that are most relevant to the company’s operations, assets, and strategic planning cycles. These timeframes should reflect when different climate-related risks and opportunities are expected to emerge or become financially material. The selection should consider factors such as asset lifespans, investment horizons, regulatory developments, and sector-specific dynamics.

3.Select appropriate climate scenarios

Choose scenarios that align with the company’s geographic, sectoral, and operational characteristics. Leveraging frameworks like the IPCC pathways or TCFD recommendations ensures credibility and facilitates access to high-quality, publicly available data tailored to these global scenarios.

4.Gather relevant data and assumptions

Collect both internal (e.g. emissions inventories, asset-level data, financial exposure) and external (e.g. regional climate forecasts, policy trends, market projections) datasets to support the analysis. Transparent and well-documented assumptions are critical to ensuring credible, consistent, and decision-useful results.

5.Model climate impacts

Use the selected scenarios to estimate how climate risks and opportunities could affect business performance, supply chains, and assets across short-, medium-, and long-term horizons. This involves formulating appropriate cost function equations for each identified risk to quantify potential impacts. For more advanced financial modelling, Monte Carlo simulations can be used to assess uncertainty and variability, ultimately producing a financial damage estimate for each scenario.

6.Assess and integrate financial impacts

Translate the modelled climate impacts into quantified financial outcomes, such as revenue at risk, cost increases, asset write-downs, or capital expenditure requirements. Integrate these figures into the company’s financial models, budgets, and strategic forecasts, ensuring alignment with accounting practices and capital planning processes.

7.Develop strategic responses and build resilience

Use the scenario analysis findings to evaluate the effectiveness of existing strategies and identify gaps in resilience or mitigation efforts. Based on this assessment, develop or refine strategic responses to address key risks and opportunities, such as adapting operational processes, investing in low-carbon technologies, or revising capital allocation plans. These forward-looking strategies should be embedded into broader corporate planning, governance, and climate-related disclosures.

Tools and frameworks

Several tools are available to make scenario analysis more efficient:

• TCFD recommendations: Risk assessment guidance on climate scenarios and financial disclosure practices.
• IPCC scenarios: Scientific and socioeconomic climate pathways for modelling temperature, emission trajectories and broader global developments.

Challenges and best practices

Common hurdles include insufficient data or expertise, uncertainty around long-term climate projections, and formulating robust cost damage functions to quantify financial impacts. To counter these:

• Employ cross-functional teams with diverse expertise.
• Leverage external advisory services or partnerships, such as RSM’s climate risk identification services.
• Regularly update scenarios to reflect emerging research and regulatory requirements.

Key considerations for compliance with IFRS S2

For companies adopting IFRS S2, aligning scenario analysis with compliance requirements is essential. Key considerations include:

• Transparency and consistency in disclosures

Provide clear, comparable, and consistent disclosures that allow stakeholders to understand the analysis process and conclusions.

• Addressing data gaps and uncertainties

Acknowledge and explain any limitations in data or assumptions to maintain credibility.

• Engaging auditors and stakeholders

Engage with internal and external auditors to validate the analysis, and communicate findings effectively to stakeholders, including investors and regulatory bodies.

By adhering to IFRS S2, companies not only strengthen their climate resilience but also build trust among stakeholders, demonstrating their commitment to sustainability.

How RSM can support climate risk management with IFRS S1 and S2

Scenario analysis plays a vital role in identifying and managing climate-related risks under IFRS S2. RSM’s IFRS S1 and S2 services can help organisations to project the impacts of potential climate pathways, enabling strategic decision-making, enhanced resilience, and adherence to global standards.