How Should Companies Identify Climate Risk Impacts on Operations and Financial Performance?

Climate change is one of the biggest issues of our time. Every company is going to be affected by climate change in one way or another. But how will climate change impact them? And how will they know? We will look at how companies need to identify these climate risks, what they need to do about them, and how they will impact short- and long-term financial performance.

The continued pervasive use of fossil fuels and the growing population has led to climate change that is disrupting the climate system in an unsustainable way for life on Earth. The average global temperature has risen by 1 degree Celsius since 1880, causing physical damage in regions all over the world. As temperatures continue to rise, events such as heat waves, floods, drought, and rising sea levels will become more common, intense, and increasingly severe. 

A warmer planet brings with it a lot of risks that businesses will have to face, such as disrupted supply chains, more expensive insurance rates, and issues with labor. 

What are the types of climate risks?

There are two main types of climate risks: physical risks, which come from changes in the weather and climate that affect the economy; and transition risks, which come from the shift to a low-carbon economy.

The general trend of increased physical climate risks across the globe, would in turn increase socioeconomic risk. They might also be significant variations between countries and even within countries.

How does climate change affect companies?

Climate change will have a significant impact on businesses worldwide through more frequent and intense extreme weather conditions. 

Companies will experience a number of negative impacts as a result of climate change, including the surface temperature rising, sea levels rising, receding snowpack, oceans warming and acidifying, disappearance of the Artic Sea ice, more violent storms and droughts, and plant and animal extinctions.

Climate change and natural disasters like hurricanes, floods, and wildfires, have a direct effect on 70% of the world’s economic sectors. In the United States, this may damage factories, supply chain operations, and other infrastructure, as well as disrupt transportation.

Drought and rising sea levels are also becoming more intense, presenting policymakers and business leaders with new challenges. They will need to reassess their assumptions about supply-chain resilience, risk models, and more in order to deal with the increased socioeconomic risk that climate change presents.

What are the climate related risks to companies?

As the impacts of climate change continue to develop, companies are now at risk for a variety of hazards such as natural disasters, technological risks, real estate loss, and an increase in energy and raw material costs. Climate change not only affects the bottom line for companies, but also their ability to maintain and reconstruct infrastructure. Both physical and transition risks impact companies in the context of climate change.

Climate-related risks can be divided into two types: those related to the physical impacts of climate change (for example, hurricanes and the rise of sea level) and those related to the transition to a lower-carbon economy (like changing market demand or carbon pricing). 

For example, companies have to face the physical consequences of climate change, like more natural disasters (violent storms, floods, fires, heat waves, droughts, etc.). If water becomes scarce, it will increase the cost of planned infrastructure projects, including hydropower. Also, weather and climate extremes are causing economic and societal problems that adversely affect supply chains, markets, and natural resources. 

There are a few risks business face when transitioning to a low-carbon society. These include the higher cost of doing business and climate change regulations. Additionally, compliance costs are generated for regulated industries. Furthermore, investors, customers, and other stakeholders demand greater transparency of climate risks. The evolving regulatory framework and changing consumer preferences add transition risks for companies looking to reduce their greenhouse gas emissions.

Failing to meet these demands could put your company’s reputation at stake.

What are the three factors of climate risk?

Risk related to climate change is typically approached by considering a combination of three components – hazard, vulnerability, and exposure. The Intergovernmental Panel on Climate Change has utilized this approach to date.

For example, extremely hot temperatures pose a risk to rail or road infrastructure because it can damage the infrastructure through its heat tolerance (vulnerability) and its location (exposure).

Is climate risk part of operational risk?

Operational risk is the risk of loss that comes from failed processes, systems, or practices. Climate change has had a serious impact on operational risk in recent years because of how extreme weather can force office closures or damage important resources, like data centers. Operational risk management is important for any organization in order to protect against these kinds of losses.

How does a Company identify climate risk impacts on its operations?

A company can identify climate risk impacts on its operations by assessing the potential physical and financial impacts of climate-related events on its business. The risks would affect the short-term and long-term financial performance of the company depending on the severity of the event and the company’s ability to recover from it. In the short term, a climate event could disrupt production and supply chains, leading to lost revenues and increased costs. In the long term, it could damage property and equipment, reduce the value of assets, and impact the company’s ability to obtain insurance coverage.

Because of their different characteristics, physical and transition risks are usually looked at separately; but, there are some climate change features that are making it more likely that these risks could affect each other, which means they should be considered together.

There are different methods that can be used by organizations to assess their climate risk. These methods include carbon footprinting, greenhouse gas inventories, process monitoring and management, systems-level analysis, and risk assessment using scenario analysis. 

The process of risk assessment is followed by risk management, where the organization can use several methods like hedge, avoidance, transfer, and acceptance. Risk management is a widely accepted approach to addressing risks, as it helps in assessing both the probability and the impact of a specific risk.

Data describing physical and transition risk drivers are the starting point for assessing how climate-related risks can impact companies. These data include climate information and information about current and projected hazard events. They may be used as explanatory variables to influence economic outcomes and alter existing economic relationships. Many types of climate risk driver data are supplied by government agencies and academic organizations.

How would the risks affect the short-term and long-term financial performance?

There exists a statistical relationship between climate and financial performance. The financial performance of the organization can be affected by climate risks in multiple ways. The risk may be direct (e.g cost of production), indirect (e.g loss of customer base from the loss of reputation), or opportunity (e.g loss of business opportunities due to a delay in the implementation of a project).

Physical risks can be identified by at-risk locations with other geographical data (e.g. topographical data including coastal elevation models, or satellite data), or cost and performance data for energy substitutes that can be used in estimating energy price relationships.

With transition risks, location is also key when it comes to being affected by national (and international) laws, local government regulations, energy grids, and consumer markets. For instance, a company’s location within a national jurisdiction can be important if the local government imposes emission policies that are more stringent than the federal policy.

A corporation that is connected to a particular energy grid within a region may face differing energy costs relative to other domestic companies on separate grids. This is due to the fact that the power supplier’s energy mix can cause disruptions.

Conclusion

When a company is evaluating growth opportunities, it should consider the climate risk impact on resources and operations. Climate risk can impact any business, and you do not need to be a specialized industry to be a victim of climate risk. The changing climate is forcing businesses to rethink business models and processes. Every company should be prepared to weather these changes.