Stress-testing the future: climate scenario analysis 

Physical climate impacts are already visible, with global insured losses from extreme weather exceeding $100bn last year.^[1] More broadly, climate change is increasingly recognized as a systemic force capable of reshaping the economic conditions underpinning long-term investment, through policy shocks, technological change and physical damage that may affect growth, inflation and asset values.

As a result, some investors are placing greater emphasis on the tools that help them fulfil their fiduciary duty. One of these tools is scenario analysis, which helps investors to test how different economic, policy and environmental pathways could affect portfolio performance over time. Rather than attempting to predict a single outcome, scenario testing can help asset owners understand sensitivities and potential vulnerabilities, supporting more informed long-term investment decisions.^[2]

Scenario analysis can be most relevant at the level of strategic asset allocation (SAA), where long-term decisions shape portfolio exposures to growth, inflation, liquidity and diversification.^[3] While climate considerations are often assessed at the asset class or fund level, a holistic perspective can reveal how risks accumulate across the portfolio as a whole and influence the macroeconomic assumptions, including the role of diversification, that underpin strategic investment decisions.

Scenario analysis can help asset owners to evaluate how different climate pathways could produce materially different macro-financial outcomes, including lower long-term growth under scenarios with more severe physical risks such as extreme heat, flooding and water stress – and higher inflation volatility and asset repricing under scenarios marked by abrupt policy tightening, energy price shocks and resource scarcity. This helps assess potential outcomes and bring discussions about long-term resilience and portfolio construction into investment committees and boards, particularly in situations where these changing dynamics might alter the behaviour of assets that have historically played stable roles in portfolios.

This approach is increasingly being embedded in the ways our financial systems themselves are assessing climate-related risk. The Network for Greening the Financial System (NGFS) has played a central role in developing standardized climate scenarios now widely used by central banks and supervisors globally,^[4] helping enable them to understand how climate and nature-related risks could transmit through the economy and, in doing so, are shaping the regulatory environment in which asset owners operate. 

Their limitations, however, are well understood. NGFS scenarios were designed primarily as policy tools, and their outputs do not map directly to portfolio returns or indicate which risks may already be priced into markets. They also assume relatively smooth transitions, whereas financial markets tend to adjust through periods of volatility and repricing. Estimates of physical climate risk remain an active area of academic debate, reinforcing the need for caution when applying such models directly to investment decisions.

For asset owners, scenario analysis is becoming far less about compliance and more of a tool for making practical investment decisions, using the analysis to inform capital allocation, risk management and stewardship priorities. Scenario analysis has also been used to prioritize engagement with companies where climate-related financial risks are most material.

Climate scenario analysis techniques can take several forms. Bottom-up quantitative models could provide granular insights at the asset or company level but may struggle to capture systemic effects. Narrative scenarios can help explore uncertainty but are harder to translate into portfolio construction. For many asset owners, top-down quantitative approaches are particularly useful, as they focus on how systemic climate risks may affect economies and total-portfolio outcomes.

At Mercer, scenario analysis is employed primarily as a decision-making tool to support strategic asset allocation and long-term portfolio design.

• Strategic asset allocation & total portfolio reviews: Scenario outputs are applied at the total-portfolio level to review long-term assumptions around growth, inflation, diversification and real asset performance. This helps asset owners understand the range of potential outcomes, identify concentrations of climate-related risk, and evaluate how alternative strategic allocations may enhance resilience across market cycles.
• Manager oversight and engagement: Mercer complements scenario analysis with Analytics for Climate Transition (ACT), a bottom-up, company-level assessment of how well portfolio holdings are positioned for the low-carbon transition. ACT does not model alternative climate scenarios but provides insight into business model resilience and transition alignment, helping asset owners prioritize manager oversight and engagement where climate-related financial risks are most material.

In an environment defined by uncertainty, scenario analysis cannot remove risk, but it can help asset owners better understand how climate risks may shape economies and markets.