The earth’s temperature has increased on average by 1.1 degrees Celsius since 1880, and it’s not stopping there. In many parts of the world, average temperatures are expected to rise by 1 to 1.5 degrees Celsius by 2050.
Though these numbers might sound small, this is an enormous change.
In fact, scientists report that the current rate of warming is at a magnitude not seen in at least the past 65 million years.
This is resulting in a wide range of climate risks and extreme weather events. Some are happening slowly over time, such as temperature and precipitation changes affecting agricultural yields or sea level rise affecting coastal areas. Others are happening rapidly, such as the onset of tropical storms, wildfires, flooding, and heat waves.
In this article, we examine the topic of climate risk. We cover important definitions, like what climate risk is and the different types of climate risk, and we provide examples of how these are playing out today.
We also look at why organizations should pay attention to climate risk – both from a costs/benefits perspective as well as a regulatory one – and we provide an overview of how organizations can begin to manage their climate risks.
Let’s get started.
What is Climate Risk?
In simple words, climate risk refers to the potential for climate change to create negative impacts on people and the environment.
Climate risk is usually determined based on a risk assessment of the scientific likelihood, consequences and responses to various hazards. It can also include a consideration of risk perception, as well as the values or preferences people have towards risk.
Climate risk is felt by everyone – individuals and organizations alike. Research has shown there are a staggering 3.6 billion people living in areas that are highly vulnerable to climate risk. Marginalized communities are particularly at risk. For organizations, climate change threatens to impact every sector, across every part of the world, with varying degrees of risk.
The Intergovernmental Panel on Climate Change (IPCC), an intergovernmental body of the United Nations responsible for assessing climate change science, says that climate risk can be understood when we look at three risk factors together:
- Hazards – the potential causes of harm
- Exposure – the extent to which people will experience harm
- Vulnerability – how strongly people will be affected by harm
The IPCC also says, with medium to high confidence, that “In the near term, every region in the world is projected to face further increases in climate hazards” and, with very high confidence, that “Risks and projected adverse impacts and related losses and damages from climate change will escalate with every increment of global warming.” (Climate Change 2023 Synthesis Report Summary for Policymakers, p. 15).
In other words, the risks of climate change are real and their effects are already being felt around the world.
Different Types of Climate Risk
When people speak about climate risk, they often parse them out into two main categories: physical risk (which include financial risk) and transition risk.
These categories were coined by the former Task Force on Climate-related Financial Disclosures (TFCD) and defined in the TFCD’s 2017 Recommendations Report.
Let’s take a closer look at what each one means, along with some examples.
1. Physical Climate Risk
Physical climate risk is defined, simply, as: risk related to the physical impacts of climate change. These risks can also include financial impacts.
Physical risks can be divided into two categories: acute risks and chronic risks.
Acute risks are those that are event-driven. They happen quickly and their impact may be shorter lived, though highly destructive.
Examples of acute physical climate risks include:
- Tropical storms
- Extreme wind events
- Extreme cold events
- Heat waves
Chronic risks, on the other hand, refer to longer-term changes in the climate. These often evolve slowly and gradually over time, though their impacts are usually irreversible.
Examples of chronic physical climate risks include:
- Rising sea levels
- Chronic heat waves
- Changes in precipitation over time
- Changes in average temperature over time
- Sustained humidity changes
- Water scarcity
The impact of the physical risks from climate change can be felt by every industry sector, in every country, around the world. These physical risks also carry inherent financial risks, and can be experienced by organizations in many ways.
We’ll talk about these ways in the next section. But first, let’s look at what a transition risk is.
2. Transition Climate Risk
Put simply, a transition climate risk is a risk that’s related to the transition to a lower-carbon economy.
In order to reduce greenhouse gas emissions and move to a low carbon economy, there must be market, technology, legal, regulatory, and policy changes. Depending on how fast this occurs, it creates different levels of reputational and financial risk for organizations.
In other words, with change comes risk (and also the potential for reward, which will talk about later on).
The (former) TFCD delineated transition risk into four categories: Policy and legal risks, technology risks, market risks and reputational risks.
Policy and legal risks stem from the fact that change is occurring and organizations need to keep up. From a policy perspective, countries are implementing requirements that aim to either reduce further greenhouse gas emissions or stimulate adaptation strategies. From a legal perspective, litigation claims have been brought forth over recent years from groups adversely affected by failures to mitigate the risks of climate change, adapt to it, or make adequate disclosures around financial risk.
Examples of climate-related policy and legal risks include:
- Expanded requirements to report greenhouse gas emissions
- Increased costs of greenhouse gas emissions
- New regulations on existing products/services
- Exposure to litigation
Technology risks refer to the ways that changing technologies create winners and losers amidst the transition to a lower-carbon economy. New technologies are created, older technologies are replaced and this can have a significant impact on organizations.
Examples of climate-related technology risks include:
- Costs to transition to lower-emitting technologies
- Failed investment in new technologies
- Resources required to replace older technologies with newer ones
Market risks relate to the changes in supply and demand for certain products/services as economies transition to lower-emissions choices.
Examples of climate-related market risks include:
- Difficulty reading market signals
- Increased costs of certain raw materials
- Changing consumer behavior and purchasing preferences
Finally, reputational risks stem from the fact that a shift to a lower-carbon economy can lead to changing consumer or community perceptions of an organization’s action or inaction.
Examples of climate-related reputational risks include:
- Increased negative stakeholder feedback or consumer concerns
- Changes in consumer preferences
- Stigmatization of certain industries, sectors or business practices
As you can see, climate change poses many risks for organizations. In the next section, we dive deeper into what these outcomes of risks can look like, and why organizations should be paying attention.
Why Organization Should Care About Climate Risk
There are many reasons for organizations to care about climate risk. Every sector will be impacted at some point, and there will be winners and losers. The actions organizations take now can set them on a trajectory for the future.
As with any change, the risks involved could result in costs. But they could also result in opportunities. We’ve examined the nature of these risks above, and now we look at the potential outcomes, should they be realized.
If climate-related risks discussed in the previous section are actualized, organizations can expect to pay a price. There are potential financial impacts to climate risk, and some of these are significant.
Here are examples of financial impacts, and their knock-on effects, that could result from physical risks:
- Loss of existing assets (e.g., because of damage due to acute events, etc.)
- Decreased revenue due to reduced production capacity (e.g., because of supply chain interruptions, damage to facilities, etc.)
- Decreased revenue/higher costs due to impacts on workforce (e.g., because of absenteeism, impacts to health, etc.)
- Increased operating costs (e.g., because of increased prices of raw materials, water scarcity, increased costs of electricity, etc.)
- Increased capital costs (e.g., because of the need to replace or repair damaged facilities, etc.)
- Reduced revenues due to decreased sales (e.g., because customers are affected, interruptions to downstream activities, etc.)
- Increased insurance premiums or reduced availability of insurance (e.g., because of claims, facilities being located in “high-risk” areas, etc.)
And here are examples of financial impacts and knock-on effects that could arise from transition risks:
- Policy and legal risks:
- Loss of existing assets (e.g., because of policy changes, etc.)
- Reduced revenues due to decreased sales (e.g., because of decreased demand for products/services resulting from fines/judgments, etc.)
- Higher operating costs (e.g., because of increased compliance costs, increased insurance premiums, etc.)
- Technology risks:
- Loss of existing assets (e.g., because of obsolete technology, new technology, etc.)
- Increased capital investments (e.g., to invest in new technology, technology development, etc.)
- Increased research and development (R&D) costs (e.g., to develop new and alternative technologies, etc.)
- Reduced demand for products/services (e.g., because of more favorable technologies, etc.)
- Market risks:
- Reduced demands for products/services (e.g., because of changes in consumer preferences, etc.)
- Decreased revenues (e.g., because of decreased sales, etc.)
- Increased production costs (e.g., because of higher costs of raw materials, water, electricity, waste treatment, etc.)
- Repricing of assets (e.g., because of changes to fossil fuel reserves, land valuations, securities valuations, etc.)
- Reputation risks:
- Decreased revenue (e.g., because of reduced consumer demand, etc.)
- Decreased production capacity (e.g., because of supply chain interruptions, poor employee retention, delayed planning approvals, etc.)
- Reduction in capital availability (e.g., due to changing preferences of investors, lenders, etc.)
On the other hand, there can be benefits for organizations that try to get ahead of, or mitigate, climate risks. Although climate change is going to continue to occur due to simple inertia, there is still an opportunity to slow it. Adaptation is also crucial at this juncture.
The EPA says, “Climate-related opportunities will vary depending on the region, market, and industry in which an organization operates” but can include:
- resource efficiency and cost savings,
- the adoption of low-emission energy sources,
- the development of new products and services,
- access to new markets,
- maximizing new policies that subsidize efficiencies and clean energy, and
- building resilience along the supply chain.
If the push and pull factor of costs and benefits isn’t enough to pique the interest of organizations, recent (and impending) regulatory requirements ought to be.
Countries and regulatory bodies around the world are introducing new or tighter requirements that compel many corporations to report on metrics related to their climate-related activities.
From a financial-disclosure perspective, this is to protect investors and reduce the incidents of corporate greenwashing.
Those who are taking action include:
- Australia – In June 2023, the Australian Treasury released a Climate-Related Financial Disclosure Consultation Paper. The paper outlines the requirements that certain Australian companies may have to follow in the future related to climate disclosures – as soon as 2024.
- Canada – In 2021, the Canadian Securities Administrators (CSA), which regulates securities and publicly-traded companies in Canada, proposed a climate-related disclosure requirement for financial institutions and ESG-related requirements for large and listed entities.
- European Union – In January 2023, the European Union’s (EU) new Corporate Sustainability Reporting Directive (CSRD) entered into force. The CSRD takes over from its predecessor, the Non-Financial Reporting Directive (NFRD), as the latest in ESG reporting for European businesses. The first companies that will be required to report using the new rules will have to do so in the 2024 fiscal year, with their reports published in 2025. These companies will be required to report using the European Sustainability Reporting Standards (ESRS).
- India – The Business Responsibility and Sustainability Report (BRSR) came into effect in 2023 and is the first framework in India that requires eligible Indian companies to report metrics on sustainability-related factors. Beginning in the 2022-2023 fiscal year, all eligible Indian companies must prepare a BRSR-compliant report.
- USA – In March 2022, the US Securities and Exchange Commission (SEC) announced that it would be proposing rule changes to require registered companies to include specific climate-related disclosures in their registration statements and periodic reports. Once finalized, these disclosures will cover information about climate-related risks that could have a material impact on their business, along with including key climate-related metrics in their audited financial statements. This will include greenhouse gas emissions disclosures.
For a deeper dive, check out our blog post: ESG & Climate Disclosure Regulations Around the World.
How to Manage Climate Risk
In light of the severity of climate risk, climate change risk management has emerged as a way to manage impacts.
There are many ways to manage climate risk, but the EPA offers a simple model involving four steps: discover, assess, report and manage.
Step One: Discover
This step will involve different activities based on the nature of your organization, but commonly includes conducting a gap analysis, engaging stakeholders to understand what metrics to report against, and creating a roadmap in alignment with any local reporting requirements.
Step Two: Assess
Step two typically includes conducting a scenario analysis to assess possible physical and transition risks, as well as opportunities. It’s important to look at location-specific information like historical weather data. From there, organizations should assess the potential impact of these risks, and establish goals, metrics, and reporting targets to help mitigate impacts.
Step Three: Report
Next comes time for reporting. This step involves developing and preparing regular reports to evaluate progress towards goals. Reporting may also be required by legislation or other requirements. It can be helpful to use a tool like FigBytes to collect data, turn insights into action, and automate reporting.
Step Four: Manage
Finally, the management phase involves implementing your roadmap, monitoring and re-evaluating risks, continually improving your processes and programs.
Take Action Today
Climate risk isn’t going away. Instead, it’s only becoming more significant. Now is the time to take action and get ahead.