Climate Resilience and Scenario Analysis
With increasing temperatures, more frequent extreme weather events, and a shifting regulatory and technological landscape, climate change presents an urgent sustainability-related risk.
Overview of Scenario Analysis
As a generational investor, Temasek closely monitors climate-related risks and opportunities across different time horizons by incorporating climate scenario analysis in our investment process and expected returns simulations. Our financial discipline in maintaining a strong balance sheet enables investment flexibility to reshape and rebalance our investment holdings as we build a resilient portfolio and deliver sustainable returns over the long term.
Against this challenging backdrop, scenario analysis is a key tool for generational investors like Temasek to manage and assess climate-related risks and opportunities under various policies, social and technology pathways, and associated temperature outcomes. This information enables us to evaluate the implications on our portfolio in different climate scenarios and make informed investment decisions.
From a top-down perspective, the climate scenario analysis is applied as an overlay on our macroeconomic forecasts alongside other geopolitical events within our Temasek Geometric Expected Return Model (T-GEM), which uses a scenario-based approach to simulate our 20-year long-term expected returns.
From a bottom-up perspective, we apply our Climate Value Impact tool, utilising a scenario-based approach, to estimate potential climate-related impacts. In addition, our internal carbon price takes into account various climate scenarios’ carbon price assumptions.
Combining both a top-down and bottom-up approach towards climate risk assessment, anchored by a consistent set of scenarios, facilitates a deeper understanding of the climate risks and opportunities our portfolio may face.
Climate Scenarios
We use three climate scenarios to assess the potential climate-related physical and transition risks and impacts on our portfolio:
Name |
Scenario |
Assumptions | Temperature Increase (by 2100) |
| Low Ambition | Network for Greening the Financial System (NGFS) Hot House World | Low Transition Costs, High Physical Costs
|
>4.0°C |
| Medium Ambition | Inevitable Policy Response Forecast Policy Scenario (IPR FPS) | Medium Transition Costs and Physical Costs
|
~1.8°C |
| High Ambition | NGFS Net Zero | High Transition Costs, Low Physical Costs
|
1.5°C |
The Medium Ambition scenario, which references the IPR FPS, constitutes our baseline. The IPR FPS was commissioned by the UN-supported Principles for Responsible Investment (PRI) and the climate scenarios were jointly developed by a consortium of technical partners. It receives strong endorsement from the financial sector, which it has been designed for.
The IPR FPS represents a high conviction policy forecast scenario and is not a normative scenario. It possesses transparency and granularity with detailed policy and technological assumptions which allows for signposting.
Given that the forecasts and climate sensitivities are subject to considerable uncertainty, we also model two alternative scenarios to simulate the range of plausible outcomes. First, the High Ambition Scenario simulates a net zero outcome, where the more ambitious goal set out in the Paris Agreement, to limit temperature increase to 1.5°C, is achieved. At the other end of the spectrum, the Low Ambition scenario simulates an outcome where climate policy traction is very weak such that global temperature increase rises above 4.0°C.
In our climate scenario analysis, the two climate risk impact channels assessed are physical risk and transition risk. For physical risk, we apply a top-down approach to assess impact on GDP growth and inflation. This includes assessing acute risks such as extreme weather events and chronic risks such as the consequences of long-term shifts in climate patterns on productivity. For transition risk, we apply top-down and bottom-up approaches. At the country level, we assess the impact of carbon taxes on government revenues and take into account second order impacts. This includes three-channel fiscal recycling of carbon tax revenues (personal tax cuts, investments, and debt reduction) and monetary policy response to changes in growth and inflation. Similarly, from a bottom-up perspective, on top of the demand creation and destruction effects that carbon taxes elicit, we consider second order impacts via company responses. This includes abatement, cost pass-through, and competition effects. The incorporation of second order impacts enhances the realism of the simulations.
We recognise the trade-off between transition risks in the shorter term and physical risks in the longer term. Whilst greater policy action may increase transition risks in the shorter term, this will reduce the magnitude of physical risks in the longer term. As a result, we adopt differing time horizons for the two categories of risk. For physical risks, we consider up to 2050 as short term and 2050–2100 as long term. For transition risks, we consider a five-year time horizon as short term, a 10-year time horizon as medium term, and a 20-year time horizon as long term. However, as implied by the differing time frames adopted for physical and transition risks, we generally expect the effects of the climate-related transition risks to occur across a shorter time horizon, over the next 20 years, and the effects of the climate-related physical risks to occur across a comparatively longer time horizon, up until 2100.
Using the risk inputs we assess as part of our scenario analysis, we mapped out the climate risk impact channels in further detail.
Impact on Expected Returns
Our most recent climate scenario analysis was carried out in 2023. Broadly, our Central Scenario incorporates the Medium Ambition Climate Change Scenario and offers higher 20-year expected returns for the Temasek Portfolio compared to the Low Ambition Climate Change Scenario, but lower 20-year expected returns compared to the High Ambition Climate Change Scenario, where there is concerted effort and strong actions to mitigate climate change and carbon emissions, for a more liveable world. These results reaffirm our belief in the importance of looking beyond portfolio decarbonisation and working to drive real economy carbon reduction through collaboration on climate action with our portfolio companies and our wider ecosystem.
It is important to recognise that whilst T-GEM simulates a range of possible returns for our portfolio over the next 20 years, they should not be viewed as predictions of actual outcomes. Rather, the climate assumptions incorporated into T-GEM assists us in understanding the potential implications of different climate scenarios and importance of building a resilient portfolio. There are several significant areas of uncertainty that we consider in assessing the overall resilience of our strategy to the climate-related risks identified and the potential impact on expected returns. This includes the complex nature of climate scenario analysis, which requires assumptions to be made on the inputs used, as well as continuous updates as data becomes more robust. In addition, the extended time horizon of scenario analysis increases uncertainty regarding the assumptions relied upon. Our assessment also depends on and makes assumptions around the response of companies to conditions or circumstances of the climate scenarios considered. Combined, these significant uncertainties increase the degree of judgement necessary to assess our climate resilience.
Likelihood of Geometric Returns (Compounded Annualised) at the End of 20-year Period, by Potential Scenario
(as at 31 March 2023)
Nature-Related Risk
If you think about this challenge – this is the race of our lives to decarbonise. The climate and nature emergency is real. And it is the race of our lives to tackle it. Fortunately, it is a solvable problem. But it’s on our watch. It’s our generation. It’s our best efforts. And with radical collaboration we can do it.
– Steve Howard, Vice Chairman, Sustainability, Temasek
We evaluate the impact of nature-related risks for sectors with material exposure as part of our pre-investment ESG due diligence. Since 2022, we have further advanced our efforts towards understanding the materiality of nature risks to our overall portfolio. In early 2022, we leveraged ENCORE1, to map how our portfolio depends on and impacts natural resources. In 2023, we participated in a Taskforce on Nature-related Financial Disclosures (TNFD) Asset Owner pilot. The objective of the pilot was to further advance TNFD’s guidance on risk assessment and quantification by testing different risk assessment approaches on real-life financial portfolios. The aggregated results and insights from the pilot fed into TNFD’s fourth beta framework.
As part of the pilot, we trialled the use of a qualitative heatmap to identify risk hotspots in our portfolio, asset tagging to quantify our exposure to nature-related risks across the value chain, and a scenario-based approach to quantify the financial implication of nature-related risks. We also gained valuable insights on the practical limitations of existing approaches to determine dependencies and impacts on nature, such as the lack of location-specific data for our portfolio companies’ key assets. As we continue to refine and enhance our risk mitigation strategies and our thinking around impact, we will draw on these insights to prioritise our engagement and advocacy efforts.
We recognise that the systemic risk posed by nature loss makes scenario analysis a relevant tool for understanding the financial impact of nature-related risks on our portfolio. We are thus closely monitoring developments around nature scenario analysis, in an effort to explore practical ways to incorporate nature with our climate scenario analysis.
