Climate risk is the measure of vulnerability to climate-related impacts that have financial consequences for your organisation or that may affect various aspects of your organisation’s financial performance. Those consequences could be anything from minor inconvenience to a complete loss of an asset’s value or operability.
Every organisation faces varying degrees of climate risk. Assessing your organisation’s climate risk and taking effective adaptation actions to reduce it can help mitigate adverse financial outcomes.
There are two types of climate risk that organisations need to understand so that they can address them: physical climate risk and transition climate risk – each with its own drivers, challenges and consequences.
What Is Physical Climate Risk?
Physical climate risk describes the potential for physical damage and financial losses resulting from exposure to climate-driven natural hazards. It accounts for both the direct physical impacts of climate change, such as floods destroying infrastructure; and the direct and indirect socioeconomic responses to climate change, such as losses caused by direct damage to assets that prevents their operability, and the costs of repairing that damage.
Physical climate risks can be either shocks or stresses. The Task Force on Climate-related Financial Disclosure (TCFD) describes climate shocks as acute risk, and climate stresses as chronic risk.
Shocks are immediate, destructive and relatively short-lived. They include:
- Flooding (including river flooding resulting from excessive rainfall or meltwater, surface water flooding or flash flooding caused by extreme rain, and coastal flooding arising from high tides and strong winds or storm events)
- Extreme wind events (including hurricanes, cyclones, typhoons and gales)
- Extreme heat events
- Extreme cold events
Climate shocks are ‘occurring with greater frequency on both a regional and global basis.
Stresses are slow in their onset. They include:
- Changes to local rainfall patterns over time – increased or decreased rainfall
- Water scarcity
- Sustained shifts in average temperatures and humidity
- Sea-level rise
Sustained shifts in climate patterns can have long-term effects on supply chains, property value and insurability. Their impact can be gradual but escalate over time.
Coincident Shocks and Stresses
Climate shocks and stresses can occur at the same time and impact each other, creating compound risks and cascading failures. For example, coastal flooding (climate shock) is exacerbated by sea-level rise (climate stress). As climate change accelerates, overall physical climate risk will continue to grow, often in non-linear ways – making it complex for organisations to adequately understand and plan for.
Calculating Physical Risk: Hazards and Vulnerabilities
According to the Intergovernmental Panel on Climate Change (IPCC), physical risk ‘results from the interaction of vulnerability, exposure and hazard’. It is the combination that reflects the complexity of a person’s, community’s or organisation’s exposure (how likely they are to experience) to hazards (climate phenomena that can cause damage), factoring in their vulnerability (how well-equipped they are to withstand a climate event).
Not all locations or assets will experience hazards in the same way, or to the same extent. For example, cities built to adapt to extreme temperatures, such as Abu Dhabi where cooling techniques are built into the architecture, will cope differently to cities such as London, where many ageing apartment towers are poorly ventilated and vulnerable to overheating. When extreme precipitation hits a city, the risk of flooding depends on the capacity of the city’s drainage system to cope with the overflow. Chicago has built ‘permeable pavements’ to cope with increasing precipitation and Tokyo has built huge storage tunnels underneath the city to capture floodwaters. On the other hand, heavy rainfall in Mumbai can bring that city to a standstill, and New York City’s drainage system was overwhelmed during Hurricane Ida in 2018. Physical risk analysis takes this complex interplay into account.
What Is Transition Climate Risk?
Transition climate risks are business risks related to a transition away from fossil fuels and other greenhouse gas (GHG)-emitting activities. Decarbonisation is critical to stabilising the climate long term, a process that will result in social, political and economic changes. The cost of decarbonising assets and operations is a transition risk, yet businesses that do not decarbonise face other types of risk such as reputational loss, loss of market share and regulatory consequences.
The energy sector is at the nexus of transition risk. The transition away from these energy sources creates transition risks for organisations that produce or rely on them. These include:
- Stranded assets and depreciation, e.g., reduced value of energy inefficient buildings
- Increased capital expenditure, e.g., from upgrading equipment or insulating buildings
- Reduced consumer demand
- Loss of market share
- Increased costs, e.g., from supply chain disruption, or the costs of raw materials
- Legal liability from failing to comply with regulatory requirements
- Financial risk, e.g., lack of insurability, or lack of access to finance, resulting from failure to comply with more stringent policy
Energy producers themselves face the dwindling value of their fuel reserves; and they take the risk of their infrastructure, such as pipelines, drilling rigs and power plants, becoming stranded assets. Downstream, businesses that rely on fossil fuel products or energy sources run the risk of disruption to their supply chains and operations.
The Connection between Physical and Transition Risks
Physical and transition risks are inextricably linked.
Owners of a manufacturing plant at high physical risk of heatwaves, for example, can either adapt their asset or continue with business as usual. If they choose to adapt, the associated costs of relocating and retrofitting the asset represents a transition risk to the business. If they choose not to respond to their physical risk, they face loss of revenue stemming from reduced workability or operability, and the depreciation of their asset as competitors adapt. Only by considering both the physical and transition risk to their assets across different time scales and climate scenarios can organisations make fully informed decisions about how best to protect their business from climate-related risks.
Mapping Climate Risks
Businesses can use ‘what if’ scenario analysis to explore how climate impacts might affect the resilience of the organisation’s business model and strategy if it were to operate in that given scenario. Climate scenarios help organisations to understand their climate risks, and how they could evolve over time, to help them make informed strategic decisions about the future of their business and assets.
Climate scenarios are analytical tools used to explore the potential impacts of climate change under different socioeconomic conditions, as well as to understand how human development and associated emission pathways affect the natural world. They help business leaders make informed decisions by considering multiple different future climate possibilities and impacts and allow them to better create strategies to mitigate damage to their assets and adapt.
Different scenarios exist for modelling physical risks and for modelling transition risks. Climate scenarios based on Earth System modelling are used to understand the physical risks posed by both shocks and stresses. Scenarios for exploring transition risk use a simpler climate model that takes energy markets and how they function into account.
To form a good idea of the range of likely risks they face and to comply with TCFD, organisations must use climate scenarios to explore their climate risk under at least three possible futures. Simultaneously, they can consider how these risks play out over different time scales and how they manifest as individual climate-affected hazards. IPCC scenarios, or possible futures, include:
- Business as usual (emissions continue to rise throughout the 21st century with no further policy intervention – the worst-case scenario for emissions)
- Emissions peak in 2040 (emissions that do not increase beyond 2040 – the middle-of-the-road scenario)
- Paris-aligned (emissions are reduced in line with the Paris Agreement, which aims to keep global temperature increases to well below 2ºC – the best-case scenario)
By using climate scenarios to understand your organisation’s physical and transition risks, you will be better equipped to make critical decisions about where to allocate resources to protect your assets.