Climate risk
Climate risk

Climate risk

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Meet our investment in this space: Climate X

TL;DR

Climate hazards will increase in frequency and severity as we are already locked into a certain amount of global warming (how much the world warms, is up to us). The financial impacts of these hazards are vast, so measuring and evaluating climate risk is becoming an essential business practice. To evaluate risk from climate change, we need to look at the full picture: hazards, exposure (physical presence), and vulnerability (the likelihood of harm).

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Risk = hazards + vulnerability + exposure

What is Climate Risk?

Climate risk refers to the interaction of climate-related hazards with the vulnerability and exposure of human and natural systems. So it is a combination of the likelihood of harm, the potential of an event to occur, and physical presence.

The components of risk are driven by both climate and socioeconomic aspects.

IPCC definitions of the terms

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Hazard: "The potential occurrence of a natural or human-induced physical event or trend or physical impact that may cause loss of life, injury, or other health impacts, as well as damage and loss to property, infrastructure, livelihoods, service provision, ecosystems, and environmental resources." (IPCC)
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Vulnerability: "The propensity or predisposition to be adversely affected. Vulnerability encompasses a variety of concepts and elements including sensitivity or susceptibility to harm and lack of capacity to cope and adapt." (IPCC)
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Exposure: "The presence of people, livelihoods, species or ecosystems, environmental functions, services, and resources, infrastructure, or economic, social, or cultural assets in places and settings that could be adversely affected." (IPCC)

Types of climate risk

Physical risk

  • Local changes directly related to climate effects
  • Will increase in frequency and magnitude under a "business as usual scenario"
  • Can be acute (i.e. extreme weather events) or chronic:

Transition risk

  • Arise from actions taken to manage climate change in terms of policy, liability, and technology
    • Includes the risk of stranded assets: carbon-intensive assets (physical and financial) that become unusable or reduced in value
  • Will increase as the world shifts to address climate change

Impacts of climate risk

Climate change poses significant financial challenges, and the risk-return profile of companies exposed to climate-related risks may change significantly as more companies are affected by climate change, climate policy, and new technologies.

Climate change is poised to reduce global GDP by 11 to 14% by 2050 (or up to $23 trillion according to The New York Times) and in the EU alone, climate-related financial losses are already averaging over ā‚¬12 billion per year.

Source:
Source: Center for International Climate Research (CICERO)

It is important to remember that climate hazards alone do not translate into impacts. The elements of exposure and vulnerability are equally as important in determining the potential impacts of risk.

Hypothetical examples

Potential ImpactExample

Sea level rise causes flooding of beachfront properties in Florida.

Labor loss in East Africa from increased malaria exposure.

Drought leads to failure of wheat crops in Canada.

More unpredictable tornadoes in Kansas leads to an increase in the cost of homeowners insurance and a decrease in the number of people who can afford to purchase or maintain coverage.

The switch to solar energy in India leads to abandoned coal power plants.

Assessing risk

When assessing risk, it's important to look at all aspects, remember:

Climate risk = hazards + vulnerability + exposure

Hazards

Traditional climate models are not fit for purpose when it comes to predicting hazards with accuracy and precision because that is not what they were designed to do. These models were designed to understand global climate change rather than to make precise regional predictions.

Researchers are using machine learning to correct conventional climate model outputs. For this method, machine learning and AI models can be trained by comparing hindcasts (predictions of past conditions) with recorded observations.

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In climate models: the smaller the area, and the further out (in time), the more uncertain the prediction will be. This will likely improve as technology advances, but more research is required.

Vulnerability and Exposure

The ability to adapt is a key component of vulnerability, and so the world's poorest countries are likely to be at more exposure risk than those with greater financial security.

Once we understand what and where the hazards are, we need to look at vulnerability and exposure to fully understand climate risk. This is where geospatial data around assets and supply chains become important.

Task Force on Climate-Related Financial Disclosures (TCFD)

Created at COP21 in 2015 by The Financial Stability Board to "develop recommendations for more effective climate-related disclosures." The TCFD outlines what to disclose against (rather than how to disclose) and consists of three parts:

  1. Core recommendations (around four themes with a total of 11 recommended disclosures)
    2. Source:
    Source: PRI, 2019
  2. Principles for effective disclosure
    1. Disclosures should representĀ relevantĀ information
    2. Disclosures should beĀ specificĀ andĀ complete
    3. Disclosures should beĀ clear,Ā balanced, andĀ understandable
    4. Disclosures should beĀ consistentĀ over time
    5. Disclosures should beĀ comparableĀ among companies within a sector, industry, or portfolio
    6. Disclosures should beĀ reliable
    7. Disclosures should be provided on aĀ timelyĀ basis
  3. Scenario analysis: hypothetical situations that consider a range of possible conditions

The TCFD in use

There are 2700 corporations, banks, national governments and government ministries that have officially supported the TCFH. Signing on as a supporter itself does not have any requirements or mean the organization is using the TCFD, rather it is a statement that the recommendations "provide a useful framework to increase transparency on climate-related risks and opportunities within financial markets." A full list of supporters is available on the TCFD website.

It should also be noted that supporting, or even using, the TCFD does not imply a commitment to reducing carbon emissions or changing business practices. The TCFD is purely a framework for disclosing risk, not fighting climate change.

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Source: TCFH

Countries with mandatory TCFD reporting

Countries with regulations in progress

On the plus side...

There are benefits to understanding and disclosing climate risk, including:

  • The ability to make more informed decisions and strategic planning
  • Attracting more investors and getting better ratings for bond issuance and bank loans
  • Improved social reputation

Resources

Last updated: Aug 2022