Facing Up to Climate Risk

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Facing Up to Climate Risk

To prepare for an uncertain future, businesses should thoroughly assess their exposure to a changing climate across both physical and transition dimensions.

As the world’s climate changes, organizations are facing myriad risks. They are confronted by physical risks, such as those arising from an increase in extreme weather events and rising temperatures, and transition risks that arise from changing regulatory environments, policies, investment decisions and public sentiment. As they are immediate and apparent with real financial impact, both kinds of risk need to be understood and addressed immediately.

Climate-related bankruptcies have already occurred. Insurance companies in the US, for example, have gone bust because they didn’t fully appreciate the physical risks arising from storms, tornadoes and flooding. This summer, the heat waves in Europe have highlighted the impact of other physical risks, such as water shortages, wildfires and lower river levels, on individuals, communities and businesses. Near-term transition risks include the prospect of more rigid and demanding regulation, changes in investor sentiment and shortages of the key minerals required to enable the transition to low carbon energy.

In an uncertain future, it is not clear whether physical or transition risks will be most pressing and hence both must be understood. The new Deloitte report: The Turning Point: A Global Summary maps out two scenarios. In the first scenario, unchecked climate change leads to US$178 trillion in global economic losses (net present value) between now and 2070 (figure 2 below).

In the second scenario, the world avoids this economic catastrophe by successfully decarbonizing by mid-century. To bring about the latter scenario, the report anticipates that governments will use policy levers and regulation to design a net-zero emissions ecosystem. 

Understanding the potential financial impact

The pandemic, conflicts in various parts of the world, the energy crisis and supply chain disruptions have meant that many organizations have yet to give climate-related risks the attention they deserve. While nearly every public company is now producing climate action reports, most have not yet tried to quantify the potential impact of climate change on their income statement and balance sheet, despite the growing demand from investors. Without this quantification, the true effect of climate-related impacts on a business are not clear, and therefore the risks cannot be mitigated appropriately. Although such modeling is difficult to do and could produce alarming results, investors, stakeholders and the general public are increasingly demanding this kind of information and transparency from businesses.

Most companies have yet to place an internal price on carbon, which is a clear way to embed climate risk into decision-making. This can help to make better-informed capital allocation decisions, such as whether to build a new factory or whether to launch a new product line. An internal carbon price can help ensure an organization continues to consider the carbon implications moving forward, rather than on an ad hoc or one off basis.

Public businesses have become proficient at modelling cash flows. Now, there is a need to embed all the material climate risk factors into these models to ensure outputs, and subsequent decisions made, reflect all the apparent risks. Once a business knows the cost of the climate crisis, it becomes more tangible and can drive action. For businesses that pivot towards a decarbonised future, there could be financial gains as the changing climate opens up new opportunities in many industries. 

Acting on what really matters

Quantitative modelling needs to be supported by an qualitative analysis to identify which factors are material. This needs to be done as a matter of urgency: Businesses will increasingly find themselves under pressure from investors, creditors, insurance companies and society to assess these risks and respond with actions, as well as promises. Inaction bears a cost as interest rates and insurance premiums may rise for businesses without plans to mitigate the climate-related risks they face. Moreover, regulatory and self-regulatory measures are proliferating at both a national and EU level. Stock exchanges, NGOs and trade associations are all demanding more information and increasing action.

Predicting the impact of physical and transition climate-related risks is complex and riddled with uncertainty. When producing excessively elaborate models, there’s a danger of fixating on numbers that obscure the bigger picture.

The impact of climate-related risks extends beyond a company’s bottom line. Social, economic and the community impact are all part of the story. Business leaders with a robust understanding of both physical and transition climate-related risks are best placed to make informed decisions and thrive in an uncertain, low-carbon future. 

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