What is climate-related financial risk and how is it managed?
Climate change impacts present financial risks and even some opportunities to municipalities, organizations, and investors across their portfolios. A set of climate risk assessment practices has emerged for entities of all kinds to manage these risks.
Climate-related financial risk is often shortened to just “climate risk,” the term I’ll use throughout this article.
Definition of climate risk
Climate risk is any financial loss linked to climate change.
For private businesses, climate-related financial losses can manifest as lower valuations of assets, increased loan defaults, underwriting risk, or even reputation and legal risks.
It has become especially important for financial institutions to manage climate risks due to the diverse macro-economic challenges—from systemic to sovereign risks—caused by climate change.
Climate risk assessment reveals how potential climate-related risks can impact assets, business operations, and portfolios across different time-horizons, while climate risk management helps entities track, monitor, and prevent unnecessary losses.
Types of climate risk
You may have heard of the NOAA’s list of “billion dollar weather and climate disasters,” which track the amount of economic losses associated with extreme weather events. These losses represent the tangible damage to the economy caused by climate change.
In addition to these direct weather-related “physical risks,” climate risk management addresses what are known as “transition risks.” These are the risks associated with the global goal of decarbonizing the economy, as outlined in the Paris Agreement.
Most nations have signed on to the goal of limiting the global average temperature to well below 2C, and limiting the global average temperature rise to 1.5C above pre-industrial average temperatures.
This goal creates risks for carbon-intense business sectors. It can also produce risks for any business entity that fails to align with changing policies, consumer perceptions, or technological advances.
Physical risk is any economic risk caused by the changing weather patterns, extreme weather events, temperature rise, and other geological impacts associated with climate change.
Physical risk falls into two main categories: acute and chronic risk.
Acute physical risks include the sudden climate impacts such as floods, storms, or heatwaves.
Chronic physical risks are linked to the long-term trends caused by climate change including the average temperature rise, sea-level rise, and other slow-moving phenomena.
Transition risk is any economic risk associated with the society-wide plan to decarbonize the economy in response to climate change.
Transition risks fall into four main categories:
Policy changes such as carbon pricing.
Technology changes such as increasing the mix of renewable energy in the grid.
Reputation risks caused by consumers’ shifting preferences such as a growing desire for sustainable products and increasing scrutiny over unsustainable business practices.
Legal risks such as lawsuits that address companies’ misleading claims or commitments linked to climate change.
Physical risks and transition risks present greater risks to key sectors. For instance, direct physical risks can significantly impact real estate, while transition risks especially impact energy companies and utilities with fossil fuel assets. On the other hand, climate risks are economy-wide, so it impacts all sectors to some degree.
Characteristics of climate risk
The key components of climate risk include “hazards,” “exposure,” and “vulnerability.”
Direct hazards of physical risk include the phenomena of geophysical change from drought to floods to sea level rise. However, these hazards alone don’t present a risk without exposure and vulnerability.
Exposure to direct physical hazards requires proximity. Sea level rise, for instance, doesn’t directly impact buildings at high altitudes.
Finally, even if you combine hazards and exposure, it doesn’t necessarily mean there’s a climate risk unless your asset has vulnerability. For real estate, a building with sufficient water pumps or storm-proofing could withstand a number of storms or flooding situations, while one built for mild conditions would not.
When considering transition risks, a similar risk assessment methodology applies.
Hazards such as policy changes are only going to cause financial losses for businesses in the jurisdictions where the changes apply. Geographic location still provides exposure.
Finally, only the businesses that have not aligned with the requirements of an updated policy face vulnerability to the consequences such as fines or fees.
Assessing and managing climate risk
Corporations and financial institutions alike can integrate climate risk as a consideration into their management of operations, assets, and portfolios.
Climate risk management strategies include scenario analysis and stress testing.
Scenario analysis: This is an exploratory method of assessing how climate risk could impact business operations and assets based on different climate scenarios. These include considerations such as an early policy scenario, a late policy scenario, and a no additional policy scenario.
The impacts of these different possible trajectories are considered on the short-term, mid-term, and long-term time horizons. Since the breadth and magnitude of climate impacts are delayed and irreversible, it is important to link the relationship between short term action and long-term forward looking outlooks.
These exploratory assessments can then inform business strategies.
Stress testing: Stress testing is a way to model how a business would perform in light of specific events or shocks to the financial system. It was a strategy used to foresee how the sub-prime mortgage crisis would impact the overall economy. Financial institutions can use similar strategies in concert with scenario analysis to predict the gravity of climate risks.
The framework providing todays most well-known best practices and recommendations for climate risk management and assessment is the Task Force on Climate-Related Financial Disclosures (TCFD).
TCFD Overview
TCFD was created in 2015 by the Financial Stability Board to offer recommendations on integrating climate risk into the financial system.
The number of organizations reporting their climate risks and opportunities under TCFD has grown significantly in a short period of time. The numbers are up a third from 2020 totaling 2,600 organizations by 2021.
Now both the UK and New Zealand have mandates for businesses and financial institutions to report in alignment with its recommendations.
The TCFD offers recommendations for entities of all sizes and financial institutions to report on their climate-related financial risks.
The four main pillars of TCFD analysis are:
Governance: Report how the board and executive management provide oversight of climate risk management.
Strategy: Report how the organization uses climate risk assessments to inform its business strategy.
Risk Management: Report the specific risks and opportunities presented by climate change impact and how the organization incorporates climate risk into its standard risk management processes.
Metrics and Targets: Include GHG emissions for Scopes 1, 2, and 3 (recommended) per the GHG Protocol, and report on targets such as alignment with the Paris Agreement.
Curious to learn more? Check out the TCFD website.