Traditionally, businesses around the world have viewed climate change from the perspective of corporate social responsibility (CSR). Treating it as a reputational risk, efforts have been limited to merely “appearing” responsible and sustainable. However, as the disastrous effects of climate change have come to the forefront, so have its associated economic and financial implications. The bankruptcy of PG&E, popularly termed the “first climate-change bankruptcy” is emblematic of the financial costs of climate change. This has led to climate change being perceived as an economic risk and not just a reputational one by companies worldwide.
What is Climate Risk?
Climate risks refer to the negative impact climate change has on an individual, company or organisation.
As Joel Makower, chairman of GreenBiz Group, articulates, “It’s no longer just about 'What business is doing to the climate.' It’s also about 'What the climate is doing to business.’”
Economic losses caused by climate change are enormous and growing. For instance, the costs of California’s 2018 wildfire season amounted to $148.5bn (0.7% of the country’s annual GDP). This is one of the many wildfires that have been increasingly occurring around the world, in addition to other extreme climatic events attributable to climate change, such as floods and droughts. With increasing frequency and intensity, these extreme events can have significant economic impact as they cause:
Supply chain disruptions: Extreme climatic events can disrupt economic activities, as in the recent case of drought in China. The drying up of the river Yangtze posed challenges in electricity generation, which led companies such as Toyota and Foxconn, among others, to halt production, resulting in the strangulation of supplies.
Increase in the price of raw materials: The price of raw materials can also shoot up due to climate-related supply chain disruptions. For instance, the recent floods in Pakistan washed away 45% of the country’s cotton crops. Being the world’s 4th largest cotton producer, it led to serious economic consequences leading to record high cotton prices.
Asset value depreciation: As extreme climatic events destroy properties worldwide, it has caused dramatic shifts in asset prices. In fact, a 2019 study which analysed real estate transactions across the East Coast and Gulf Coast revealed that frequent floods led to a $15.9 billion loss in home value appreciation in the last 12 years alone.
Regulatory risks: In response to the accelerating climate crisis, governments and regulators have been developing regulations to tackle the problem. The rapidly developing regulations, however, tend to pose a severe transition risk to businesses by increasing operational costs, undermining the viability of their products or impacting asset values.
Thus as the crisis worsens, its effects are felt more widely, impacting almost every single entity on the planet.
Bob Moritz, the Global Chairman of PwC, stated on the matter that, “it’s a rare business that has no offices, plants, or people in affected areas; no upstream suppliers or downstream customers exposed to a changing climate; no reliance on natural resources or ecosystems; and no vulnerability to climate-driven political instability, resource shortages or economic downturns.”
Developing Risk Management Tools and Approaches
The rate at which the climate crisis has been accelerating has alarmed experts worldwide. Mark Carney, the former Governor of the Bank of England, says that the stage is set for what could possibly be climate risk’s “Minsky moment”, a sudden and vast realisation of the enormity of climate risk, possibly leading to sudden drops in asset values for vulnerable companies. Cognizant of this risk, along with the rising pressure to decarbonise by investors and consumers and rapidly developing regulations, stakeholders have been developing approaches to understand and gauge their exposure to climate risks.
This enables them to identify climate risk blind spots and helps in strategic planning. For example, governments can anticipate probable risks and build resilience accordingly. Likewise, companies can relocate their manufacturing or storage hubs to less vulnerable areas, and individuals may be able to make better investment decisions.
Some of the popular approaches to efficiently measure climate risk are:
Value at Risk (VaR)
VaR is one of the most popular statistical measures of market risk among investment managers, banks, asset owners and insurance companies. Based on probability, it quantifies the risk of probable losses for a firm, investment or portfolio in a specific time frame. VaR is calculated by assessing three important factors: minimum loss, specified time period and probability of exceeding that loss.
VaR can be calculated through several ways. Among these, the three major methods are:
The Historical Method: This method uses historical data to assess the impact of market developments on a portfolio. It works on the assumption that history will repeat itself.
The Variance-Covariance Method: This method primarily focusses on the “standard deviation of price movements of an investment or security”.
The Monte Carlo simulation: This method uses computational models to generate trials in a random manner, without disclosing the underlying methodology. Considered a “black box” generator, it bring out random and probabilistic outcomes.
Through VaR modelling, risk managers can undertake risk analysis for both specific positions as well as for the entire firm. These insights allow an entity to assess if they have sufficient capital reserves to make up for the losses or if they need to take additional measures to effectively deal with the potential crisis. This further helps companies understand how the climate change crisis could impact their valuations.
VaR modelling has emerged as a popular choice having acceptability across most regulatory authorities, owing to its several advantageous characteristics. This includes comparability, as it can be used to assess the market risk of asset classes with different risk characteristics. In addition, it is easy to interpret since VaR is measured in currency or percentage format, making it convenient for analysts. However, it is not devoid of shortcomings either. For instance, VaR does not articulate the expected losses if it moves beyond the minimum threshold and is difficult to calculate for more extensive portfolios.
Stress Testing (ST) is another notable tool used to measure climate-related risks. It functions with the objective of determining how climate-related risks impact an entity across geographical areas under different climate scenarios. With its “what if” approach, ST assesses different scenarios that pose a significant danger to the financial well-being of an entity. The results enable stakeholders to undertake measures to respond to big economic shocks and other potential challenges in an effective manner. For example, based on the stress test results, financial institutions can arrange resources that will help the institution absorb shocks across different scenarios. Likewise, in the case of financial services, if a bank fails a stress test, it may be prohibited from carrying out certain activities, such as paying dividends.
Climate-related stress scenarios ideally incorporate three major types of climate risks:
Physical risk: This refers to physical damages caused to property or infrastructure by climate-related disasters such as floods, wildfires, droughts etc.
Transition risk: These emerge from policy and regulation changes in response to climate change. For example, governments can pass new laws to reduce emissions or increase carbon taxes, which can significantly impact a company's operations.
Liability risks: These emerge from legal suits that call for compensation for various climate-related problems. For example, a company may be sued for causing significant harm to the environment or for not disclosing climate-related risks in a credible manner.
Stress tests help companies and investors get a clear picture of the implications of potential climate-related risks in the future. In addition to ensuring better preparedness, by enabling better financial planning, it also benefits companies as they conceptualise their net-zero roadmaps. It also helps in recognising a company's strengths and weaknesses. However, stress testing too has its limitations. For example, while it estimates the exposure to a risk, it does not assess the probability of such an event taking place. In addition, it also has high computational costs and is a complex task to administer.
As it is established that climate-related risks will likely worsen in the coming years, it becomes imperative to properly understand these tools and concepts to adapt efficiently. They play an important role in identifying climate risk blind spots and driving better operations and investment decisions. However, these tools are only as good as their inputs. Hence, high-resolution, high-frequency and granular data would play a crucial role in the adoption and success of these tools, thus shaping the credibility of these approaches.
Follow our website as we explore the subject of climate risk, its financial implications and the role of data in managing climate risk in greater depth in our upcoming blogs.