Climate financial risks for companies
Climate financial risks refer to the set of potential risks that may result from climate change and that could potentially impact the safety and soundness of individual financial institutions and have broader financial stability implications for the banking system. These risks are typically classified as physical and transition risks.
Physical and transition risks
- Physical risks include the potential economic costs and financial losses that result from the increasing severity and frequency of extreme climate change-related events, and longer-term progressive shifts and global trends in the climate.
- Transition impacts are related to the process of adjusting the company to a low-carbon economy.
Causes of financial climate risks
In the context of climate change, climate financial risk is due to interactions between climate hazards, exposure, and vulnerability of socio-economic and natural systems. These risks depend on natural hazards, exposure, and vulnerability of companies.
Key risks have potentially severe adverse consequences for companies resulting from the interaction of climate-related hazards with vulnerabilities of societies and systems exposed.
How to assess climate risks
- Risk is the combination of the likelihood of an event and its consequences.
- Likelihood can be dependent on the hazard or its consequence.
- Hazard is defined as the potential occurrence of a natural or human-induced physical event that may cause negative impacts to humans. (loss of life, injury, and health impacts). As well as economic impacts (damage and loss to property, infrastructure, livelihoods, service provision, natural systems, and resources…).
- Exposure is related to the presence of people, livelihoods, infrastructures, resources, and species that could be adversely affected. Vulnerability is defined as the predisposition to be adversely affected.
What can companies do to manage climate risks?
There are two approaches to managing climate risks:
- Adaptation that seeks to reduce the company’s vulnerability to a given climate hazard
- Mitigation of greenhouse gases emitted by the company intended to reduce the magnitude and frequency of climate hazards.
Companies can develop strategies to facilitate the development of long-term operational resilience, and at the same time, support efforts to mitigate the effects of climate change. The initial focus for companies is to determine their greenhouse gas emissions and try to reduce them. This will fall under transition risks and typically relates to associated policy changes with respect to emissions reduction targets.
Material climate risks mitigation
However, this focus may overlook other material climate risks such as customer demand, investor expectations, and opportunities that technological changes may offer. In contrast, physical risks tend to be the least well understood, with a focus on the chronic physical risk of sea-level rise. However, companies are also already being confronted with floods, fires, droughts, and record temperatures. These are not only societal issues but also represent important risks to business operations as they may damage premises, harm their employees, and cause disruption to the supply chain.
Reducing financial risks
Initiatives to reduce climate financial risks can be taken such as:
- Enhancing and sharing knowledge and information about climate change
- Assessing and modeling current and future climate variability
- Predicting long-term trends in climate change
- Forecast occurrence of extreme events and their impacts
- Analyzing implications for companies’ sustainable development.
Managing climate risks in the renewable energies sector
Two examples are further developed to illustrate companies’ governance of climate risks and risk management processes: the sector of renewable energies and sustainable finance.
Renewable energies and vulnerability to climate change
Within energy system transitions, the most feasible adaptation options support infrastructure resilience, reliable power systems, and efficient water use for existing and new energy generation systems.
Energy generation diversification, including renewable energy resources that can be decentralized depending on context (wind, solar, small scale hydroelectric. Same for demand management (storage, and energy efficiency improvements) which can reduce vulnerabilities.
The transition to renewable energies
The transition to low carbon renewable energies will bring major structural changes in power systems around the world. The energy transition aims to gradually move from an energy system based essentially on fossil fuels (e.g coal, oil, natural gas) which are limited in nature and emit greenhouse gases. Switching to diversified, renewable, and decarbonized energy sources (e.g wind, solar, hydraulic, geothermal, biomass). Variable renewable energy generation has already increased significantly over the past decade.
Uncertainties in the transition to renewable energies
Renewable energies promise to provide a better and cleaner future. However, renewable energy is today still viewed by many insurers as risky. Uncertainties associated with this sector are limiting the involvement of insurers, and therefore also limit the appetite of investors, who rely on the insurers to take on the project risk at a set insurance premium (price), thereby smoothing project cash flow and predictability.
Sustainable finance in the context of climate change
The global awareness of human activity’s climate impacts has accelerated the shift towards sustainable finance and exposed insurers to public and regulatory scrutiny—defined by the European Commission as the finance for investments that account for the environmental, social, and governance impact of their investment decisions.
Moodys has stated that environmental, social, and governance (ESG) risks are of increasing importance to insurance regulators worldwide. In their report, they state that because the insurance industry controls and manages a significant portion of global investable assets. At the same time, they provide risk transfer services fundamental to the healthy functioning of commerce and society at large. Therefore, insurance companies must be at the forefront of the global movement toward sustainable finance.
Investing and Insuring business
The following international developments have added to this shift:
- 2015 Paris Climate Agreement,
- 2015 UN 2030 Agenda for Sustainable Development
- 2018 European Commission’s Action Plan on Sustainable Finance.
In response to pressures and their own assessments of ESG opportunities and threats, insurance companies have been implementing measures on both the insurance risk-transfer side of their business as well as their institutional invested asset business.