Climate Scenario Analysis

Climate scenario analysis is a forward-looking analytical approach used to evaluate how different climate-related futures may affect financial institutions, markets, and the broader economy. Within banking and finance, it examines the potential impacts of climate change under alternative pathways of physical climate outcomes and transition dynamics. For the Indian economy, climate scenario analysis has gained increasing significance due to India’s high climate vulnerability, development needs, and expanding financial system. It provides a structured way to understand long-term risks and opportunities associated with climate change and to support resilient, sustainable economic planning.

Concept and Rationale of Climate Scenario Analysis

Climate scenario analysis differs fundamentally from traditional financial forecasting. Rather than predicting a single expected outcome, it explores multiple plausible futures based on varying assumptions about climate policies, technological change, economic behaviour, and environmental responses. These scenarios are not probabilities but structured narratives designed to test resilience under uncertainty.
In banking and finance, climate scenario analysis helps institutions assess exposure to climate-related financial risks, identify potential stress points in portfolios, and evaluate strategic responses. It complements climate risk stress testing by focusing more on qualitative and medium- to long-term strategic impacts rather than short-term capital adequacy alone.

Types of Climate Scenarios

Climate scenarios are commonly classified into three broad categories. Orderly transition scenarios assume early and gradual policy action, technological innovation, and behavioural change, resulting in lower long-term economic disruption. Disorderly transition scenarios involve delayed or abrupt policy interventions, leading to sharp asset revaluations and higher financial instability. Hot house world or physical risk–dominated scenarios reflect limited climate mitigation, resulting in severe physical impacts such as extreme weather events, productivity losses, and infrastructure damage.
Many financial institutions and regulators base their scenario design on reference pathways developed by the Network for Greening the Financial System, which provides globally consistent climate-economic scenarios adapted to national contexts.

Application in Banking and Financial Institutions

Banks and financial institutions use climate scenario analysis to examine how climate risks could affect credit quality, market valuations, operational resilience, and business models. Loan portfolios are assessed against sectoral vulnerabilities, particularly in climate-sensitive industries such as agriculture, energy, transport, real estate, and manufacturing.
Scenario analysis also supports strategic planning by helping banks evaluate future demand for financial products, shifts in investment preferences, and the long-term viability of carbon-intensive business lines. It encourages integration of climate considerations into governance, risk appetite frameworks, and internal capital allocation processes.

Importance for the Indian Economy

India’s economy is uniquely positioned at the intersection of climate vulnerability and development imperatives. Agriculture remains a major source of employment and income, while rapid urbanisation and infrastructure expansion increase exposure to climate-related physical risks. At the same time, India’s energy transition towards renewables introduces transition risks and opportunities across the financial system.
Climate scenario analysis enables policymakers and financial institutions to explore how different climate pathways may affect economic growth, employment, inflation, and fiscal stability. It is particularly relevant for assessing regional disparities, as climate impacts vary significantly across India’s states and sectors.
India’s climate commitments under the Paris Agreement further underscore the importance of scenario analysis in understanding the financial implications of decarbonisation and adaptation strategies.

Role of the Reserve Bank of India and Regulators

The Reserve Bank of India has increasingly acknowledged the relevance of climate scenario analysis for financial stability. While still at a developmental stage, Indian regulators have encouraged banks and non-banking financial companies to adopt scenario-based approaches to climate risk assessment and disclosure.
Regulatory interest in scenario analysis reflects its value as a diagnostic and learning tool rather than a prescriptive regulatory requirement. It helps supervisors understand systemic exposures, data gaps, and transmission channels of climate risks within the Indian financial system.

Methodological Approaches in the Indian Context

Climate scenario analysis in India typically combines qualitative narratives with quantitative modelling. Sector-level impacts are mapped onto macroeconomic variables such as output, productivity, prices, and employment. These macro effects are then translated into financial metrics including credit risk, asset valuations, and investment performance.
Given data and modelling constraints, Indian institutions often adopt simplified or exploratory approaches. These may include sensitivity analysis of key sectors, regional exposure mapping, and use of proxy indicators for climate vulnerability. Over time, methodological sophistication is expected to improve with better climate data, geospatial analysis, and collaboration between financial institutions and climate research bodies.

Benefits for Financial Stability and Sustainable Finance

Climate scenario analysis enhances financial resilience by promoting anticipatory risk management rather than reactive responses. For banks, it supports better identification of long-term risks and opportunities, enabling more informed lending and investment decisions. For the broader financial system, it contributes to stability by reducing the likelihood of abrupt asset repricing and systemic shocks.
The insights generated through scenario analysis also support the growth of sustainable finance in India. By highlighting the relative resilience of low-carbon and climate-resilient investments, scenario analysis helps align financial flows with sustainable development objectives.