What is climate risk and why does it matter?

What is climate risk and why does it matter?

It is highly unlikely that your business will be free from of any risk posed by climate change. Quite the opposite considering this summer’s record-setting heat waves which threatened lives, destroyed buildings and upended daily routines. As extreme weather events become increasingly intense, frequent and long lasting it is essential that organisations of all sizes examine the risks that climate change and biodiversity loss poses to their value chain in order to help them reduce and manage the impacts.

Risk analysis has been used by businesses since the 1970s to inform their strategy and for stress testing purposes. However, its application to assess climate and nature related issues is relatively recent. As the climate and biodiversity crisis accelerates many organisations are choosing to conduct them for the first time and in some jurisdictions, such as the UK and EU, they are becoming mandatory under new reporting regulatory requirements such as under the Task Force on Climate-Related Financial Disclosures (TCFD) and Corporate Sustainability Reporting Directive (CSRD).

What is meant by climate risk?

Climate-related financial risk falls into two main categories:

1. Risks related to the transition to a lower-carbon economy and

2. Risks related to the physical impacts of climate change.

Transition Risks:

Transitioning to a lower-carbon economy may entail extensive policy, legal, technology, and market changes to reduce the severity of climate change and adapt to its impacts. Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to organisations.

As an example, European countries are currently seeing an increase in policy risks as governments legislate for the transition to a net zero economy. Countries across Europe are implementing carbon-pricing mechanisms such as carbon taxes, shifting energy use toward lower emission sources, adopting energy-efficiency solutions, encouraging greater water efficiency measures, and promoting more sustainable land-use practices. The risk associated with each policy change will depend on the nature of your organisation and timing of the policy change.

Physical Risks:

Physical risks resulting from climate change can be event driven (acute) or longer-term shifts (chronic) in climate patterns. Physical risks may have financial implications for organisations, such as direct damage to assets and indirect impacts from supply chain disruption. Organisations’ financial performance may also be affected by changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting organisations’ premises, operations, supply chain, transport needs, and employee safety.

As an example, this summer saw forest fires rage across Europe with the UK Met Office, issue its first-ever “Red Extreme” heat warning. This was coupled with nearly half of the EU being exposed to dangerous levels of drought which impacted water availability and crop yields in the UK France, Romania, Spain, Portugal and Italy. These represent chronic physical risks as they refer to longer-term shifts in climate patterns and will have a significant impact on the hospitality, healthcare and agriculture industries. It is essential that all organisations understand how these risks could impact their value chain now and conduct scenario analysis to examine how future climate related events will affect their organisation.

What is Scenario Analysis?

Scenario analysis allows a company to understand and quantify the risks and uncertainties it may face under different hypothetical futures. It helps in decision making and allows businesses to shape their strategy. In the light of scenario analysis outcomes, businesses can focus on those key risks and opportunities that most materially impact their business models. This, in turn, allows them to develop their mitigation plans and respond appropriately to these risks through strategic decisions.

The use of climate scenarios is recommended by the Task Force on Climate-related Financial Disclosures (TCFD) as a tool to identify and assess how various combinations of climate-related risks may affect organizations and their financial performance. It is anticipated that it will also be required by the EU Corporate Sustainability Reporting Directive (CSRD) which means that approximately 50,000 entities who operate in the EU will be required to perform it and disclose their results on an annual basis.

We recommend that organisations consider a set of scenarios, including a ‘2°C or lower scenario’ in line with the 2015 Paris Agreement. This low-carbon scenario is centred on ‘transition’ risks and looks at the rapid changes (policy, technology, market and reputational risks) that will be needed to cut emissions in line with the Paris Agreement. Organisations should also conduct ‘physical’ risks scenarios that focus on risks, such as temperature rise, sea level rise, and changes to the frequency and severity of extreme weather events, including droughts and storms.

Conducting a scenario analysis with expert input is important as it will be used by investors and other stakeholders to understand how your organisation is transitioning to the net zero economy and how you are addressing physical risks and other vulnerabilities to your value chain.

As a reference, the Climate Disclosure Standards Board “TCFD Good Practice Handbook” highlights current examples of good practice disclosure from within companies’ mainstream financial reports, which are aligned with the TCFD recommendations.

We are here to help you

Performing climate and nature related risk and scenario analysis can be a challenging and demanding task due to the complexities that it carries. Climate scenarios are particularly challenging given the timescale, complexity of the scientific models, and the multi-faceted nature of consequences of each scenario require real skill and judgment to help simplify and focus on the key elements.

We work with businesses across all sectors to support them in their climate and nature related risk and scenario analysis. We are ready to help you. Contact us today.

Ciarán O’Carroll - Director of Development

Ciaran@changebydegrees.com

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