Businesses should evaluate the risks and opportunities of climate change and its mitigation to ensure their long-term resilience and success.
Pushed by consumers and investors, large businesses and increasingly also small and medium-sized enterprises (SMEs) are getting increasingly used to assessing and communicating how their operations, products and value chains impact society and the environment. Many businesses have also started taking concrete actions to lessen their environmental impacts (for example, by reducing their emissions), or to enhance their positive contributions (by commercialising carbon-neutral products, for instance) to help fight climate change. The next challenge is tackling the other side of the coin: evaluating how climate change and the policy interventions aimed at mitigating its effects will affect businesses.
The global delay in fighting against the Earth’s rising temperatures has two important consequences, with far-reaching impacts on businesses’ profitability and long-term resilience. First, despite global emissions reduction efforts, we’re no longer fighting to avoid climate change impacts, which have by now become inevitable, but against the unmanageable ones expected if global temperatures increase by more than 1.5 degrees Celsius. Hence, businesses – especially in sectors that critically depend on the climate and natural resources – need to adapt to new environmental conditions and increasingly frequent extreme weather events.
Second, this delay is pushing many countries to put their foot on the accelerator to prevent disastrous outcomes. This means that policy interventions such as carbon taxes, new subsidies for green energy and low-carbon technologies as well as cuts to those destined for fossil fuels, compulsory energy efficiency standards and the like are to be expected in many countries in the next few years. For example, in Switzerland a total revision of the so-called CO2 law is being discussed in parliament in these months. This means that some businesses may soon see a surge in their operational or investment costs to comply with new regulations.
Climate change has originated new material risks (physical and transition risks) and has increased reputational risks for businesses. Moreover, access to finance is becoming increasingly linked to companies’ climate-related risks.
In the last couple of years, a new terminology has emerged to explain the different types of climate change-related risks that businesses face. Physical risks are directly related to climate change impacts, such as a hurricane or flood destroying a production plant or climate variability affecting crop production. Transition risks are linked to expected policy changes in moving towards a low-carbon economy, such as carbon taxes or minimum energy efficiency standards. Finally, reputational risks are nothing new for businesses, but they’re now increasingly associated to insufficient action in curbing greenhouse gas emissions.
Beyond these three categories, an extremely important factor for companies is access to finance, which is increasingly linked to climate-related risks because financial institutions are themselves exposed to more credit, market and reputational risks as a consequence of their clients’ and investees’ climate-related ones.
On the debt side, Banca d’Italia (Italy’s central bank) recently estimated that between 36.5 and 52.9 per cent of loans granted by Italian banks are exposed to transition risks, while for other major EU countries such as Germany and France these percentages are even higher. In other words, this means that if these governments decided to pass ambitious laws to accelerate the transition towards a low-carbon economy, carbon-intensive companies would incur in higher costs, which may prevent them from repaying their debt. In turn, this would weaken banks’ balance sheets.
As a consequence, financial regulators all over the world are taking action to mandate disclosure of climate-related risks by supervised institutions as a first important step to keep them under control. Moreover, banks also face reputational risks when their loan and asset portfolios are too oriented towards carbon-intensive activities. For example, Credit Suisse, the second largest Swiss bank, is facing unprecedented protests and demonstrative actions from civil society because of its “brownish” loan and asset portfolios. All of the above explains why many banks are rapidly revising their credit and investment guidelines away from carbon-intensive clients and assets.
The story is similar on the equity side. Investors active in financial markets are factoring-in the risk of new climate-related regulations and, more generally, consider companies with high environmental, social and governance (ESG) performance more promising than “brown” or low ESG rated ones. Moreover, many asset managers, including giants such as Black Rock, are responding to their clients’ growing sustainability concerns and, as a consequence, the demand for carbon-intensive assets is becoming more volatile.
This can be clearly seen in the effects of the global financial crisis caused by the coronavirus pandemic on traditional versus sustainable asset portfolios, with major ESG investment funds outperforming the S&P 500 (an index that represents the stock market’s performance by reporting the risks and returns of the US’ 500 biggest companies). Last but not least, institutional investors such as pension funds may be exposed to liability risks deriving from neglecting climate-related risks in their investment choices. Hence, companies with high climate-related risks or poor ESG performance may find it increasingly difficult to raise capital on financial markets.
For companies in many sectors, climate-related risks are material and depend on the industry, location of production and company assets, as well as the carbon footprint.
Physical risks mostly affect businesses whose production depends on climatic conditions or on the predictable and sufficient availability of natural resources. Examples are the food and beverages sector, winter tourism and hydroelectric power generation. Beyond the type of economic activity, where production and physical assets are located is also a crucial element for assessing physical risks: while climate change affects the whole planet, the type and magnitude of impacts are location specific.
For example, some areas will become more prone to hurricanes while others will be affected by more frequent droughts. Latest generation climate models have become very precise in estimating the location specific effects of climate change, although uncertainties still exist and the impacts in the coming decades will crucially depend on our ability (or inability) to limit global temperature increases.
It’s important to stress that physical risks may be particularly significant even for carbon neutral companies. A good example is hydroelectric power generation: unpredictable rainfall, prolonged dry periods and heavy rains causing more debris in water basins are challenging big and small producers. Anna Birolini, owner of four small hydroelectric plants in northern Italy, says she’s finding it extremely difficult to decide between renewing the facilities or selling the business as production is becoming increasingly unpredictable and operational costs are increasing, for example because big machinery is more frequently needed to take debris out of water canals.
Businesses in other sectors can also be badly affected by physical risks as a consequence of extreme weather events and climate change-related natural disasters. The most famous case is that of the Pacific Gas and Electric Company in California, which in January 2019 was the first company to file for bankruptcy as a result of climate change: its service area was swept by wildfires following extremely hot and dry conditions, causing liabilities of 30 billion US dollars or more.
More recently, Australia’s bushfires have been damaging businesses in many sectors. “As Australia’s deadly bushfires rage, many companies are reporting hits to business with resorts shutting their doors, cheesemakers struggling to secure milk supplies and insurance claims on the rise,” Reuters wrote in January 2020. Damages reported by businesses don’t include the biggest loss resulting from such catastrophic manifestations of climate change: that of wildlife and habitats, which, according to many scientists, can have negative consequence for human beings too, such as the increased risk of pandemics.
Sectors affected by transition risks, on the other hand, are easier to identify as these are directly linked to businesses’ exposure to fossil fuel supply chains and the resulting carbon footprint. Examples include utilities, mining, transport as well as manufacturing and construction. Within these sectors, businesses delaying adoption of existing economically viable low-carbon technologies are particularly exposed to reputational risks. “These sectors have faced the bulk of stakeholder activism around improved climate disclosures,” according to professional services firm Ernst and Young. “Actions such as lawsuits and shareholder resolutions relating to climate risk have been directed towards the largest global organisation within these sectors”.
Within the financial sector, for the time being transition risks have been more of a concern compared to physical ones, with attention by central banks and financial regulators, as well as institutions’ financial risk disclosures, generally more focused on this category. Reasons may include a relative methodological simplicity in estimating transition risks compared to physical risks, the expectation that transition risks will manifest themselves before physical ones (as new regulations are expected soon in many countries) and the fact that unmanaged transition risks can amplify reputational ones.
Nevertheless, it can be expected that physical risks will soon come under the radar of many financial institutions since crucial business lines, such as those of mortgages or loans in climate-sensitive sectors, may be badly affected by climate-related extremes and disasters. For example, Land Bank, a leading lender in agriculture in South Africa, whose retains 29 per cent of the country’s agricultural debt market share, has recently defaulted on two of its domestic medium-term notes and been downgraded by credit rating company Moody’s into junk status. Climate risks have been recognised as a joint cause for the default since prolonged dry periods have impacted farmers’ ability to repay loans.
Physical risks are very relevant for other financial actors as well, such as asset managers, investors and insurers. A recent contribution by economist Mark Westcott and others, for example, proposes a methodology that real estate investors and lenders can use to improve their understanding and management of physical risks. Results from applying the methodology to a sample of twelve real estate portfolios to investigate the impacts of climate change on losses from floods and winter storms in the UK as well as tropical cyclones in North America and the Pacific Rim aren’t negligible and, the authors conclude, “raise important questions for investors, lenders, insurers and policymakers as to how these new levels of risk can be managed in the most cost-effective manner”.
Understanding climate-related risks before they materialise allows for planning, financing, and implementing risk management measures at lower costs, higher reputation-related returns and benefits in terms of long-term business resilience and profitability – compared to a wait-and-see strategy. A blooming green finance sector provides numerous opportunities for transition risk mitigation, while better models are becoming available to help businesses manage physical risks.
Good risk management starts with proper risk assessment. The sooner companies get acquainted with identifying and assessing these new types of risk along their value chains, the better they can act to decrease the probability of incurring in liquidity problems or losses in years to come as a result of compromised access to finance, costs of complying to new regulations or damage costs due to climate-induced natural disasters.
A transition risk assessment exercise is particularly advisable for financial institutions also in view of upcoming regulations on climate-risk disclosure, while industrial sectors in the real economy might benefit from using their resources directly to prepare and implement a sound and credible strategy to significantly lower their carbon footprint. Benefits in terms of reputation, easy access to green finance and possible savings in long-term operational costs justify early action, even in countries where the political landscape isn’t ready for ambitious regulatory measures to decarbonise the economy.
High-carbon businesses with limited and costly possibilities to reduce their emissions, such as coal utilities or oil and gas companies, are particularly exposed to transition risks and increasingly difficult access to finance. With carbon taxes on the agenda of many governments, investments in climate-friendly funds skyrocketing and financial actors increasingly committed to reducing loan exposure in these sectors as well as divesting from high-carbon assets, these companies have to make a crucial decision: either significantly reduce their short-term profit margins by massively investing in low-carbon technologies, carbon sequestration and offsetting projects, or taking the opportunity to entirely rethink their core business, for example by making forward-looking investments in startups working on the technologies of the future.
On the physical risk side, an assessment exercise may be meaningful for both the financial and non-financial sectors. Climate-vulnerable industries should base their strategic and investment decisions on science-based information about the expected impacts induced by climate change. Latest generation probabilistic climate models provide much better tools for decision-making compared to a few years ago, thanks to small-sized grid cells and hence a much higher level of detail.
Although the application of these models to business uses is still in its infancy, this is a field that can be expected to grow very fast in the years to come. Models’ outcomes and expert advice can help companies decide which investments make more sense, where to set up new facilities and how to better protect their assets from extreme weather events or other climate-induced natural disasters through climate-resilient infrastructure, nature-based solutions or insurance. Financial institutions and asset managers, on the other hand, can benefit from these models to better assess and manage their credit risk and risk-adjust their investment portfolios.
The business landscape is changing fast, with new risks and opportunities becoming inextricably linked to our planet’s fever. There will be winners and losers. Companies embracing climate risk assessment and management early on have bigger chances of prospering in the next decades.
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