What Is Climate Risk And Is It A Useful Concept?

by Annabel Solnik

It is now widely recognised that climate-related impacts are not just a future threat [1]. They are already felt across the globe by communities, governments and businesses alike. Climate risk provides a way for the private sector to quantify the real or potential impacts of climate change. In business, risk is defined as the exposure a company or organisation has to factors that lower its profits and lead to failure [2]. Therefore, most companies manage risk carefully and are willing to pay large amounts for advice on how to reduce risk. It is estimated that the global risk management market will reach 17.1 billion USD by 2021 [3].

Climate change creates physical, transition and liability risk. Physical climate risks are economic costs that result from increasing frequency and severity of extreme weather events, such as heatwaves or floods, long-term gradual shifts in climate, such as rising sea levels, and also indirect effects of climate change, for example biodiversity degradation. Studies show that these risks are only increasing as more greenhouse gases are released in the atmosphere [4, 5].

Transition risk arises from the move towards a low-carbon economy and is driven by changes in regulation, reporting standards, technology, markets and consumer preferences. A regulatory example is the carbon tax on industrial polluters imposed by the Dutch government in 2021 [6]. A market change example would be inventors pulling out fossil fuel companies as they see their assets becoming increasingly stranded in the future due to a shift to a low-carbon world [4].

Liability risk emerges from people and businesses seeking compensation for losses they have endured due to the physical or transition risks. The risk is realised when people negatively impacted by physical climate events make claims against companies they held responsible. For example, in 2019 Dutch activists took the fossil fuel giant Shell to court. The landmark case resulted in the court ordering Shell to significantly reduce its GHG emissions [7]. Liability risk can also realise when investors are unhappy with company performance or their influence on sustainability regulation [8].

Climate change is a complex, multidisciplinary challenge, therefore, it has been argued that no risk parameters or models can truly encapsulate the complexity of global climate change [9]. Risk models need to be able to capture measurable physical impacts, such as damage to infrastructure in USD (physical risk), but also less quantifiable long term political and societal transition to low-carbon economy (transition risk) [8]. Based on ambiguous data and complicated calculations, models can often overestimate the cost of action and underestimate the speed of new technology deployment. This can easily send a signal for companies to continue with business-as-usual.

On the other hand, managing climate risk and quantifying potential and realised impacts helps companies or whole industries transition faster. As businesses have a large role to play to keep global warming to 1.5 degrees, we need them on board. Climate risk helps them understand the cost of inaction, such as facing liability, reducing profits and becoming outdated in a fast-changing world.

Climate risk is far from being a solution to climate change, but increasing losses on bank’s balance sheets can help them rethink their business models.

In conclusion, climate risk helps to translate the impacts of climate change into business language. Although the models are not always as accurate as we would hope, quantifying climate risk helps to show the cost of inaction and get the private sector on board for the fight against climate change. With new temperature records being set and the global carbon budget running out, we need al hands on deck. Climate risk is far from being a solution to climate change, but increasing losses on bank’s balance sheets can help them rethink their business models.

Reference List

[1] UNFCCC (2007). Climate related risks and extreme events.  Available from: https://unfccc.int/topics/resilience/resources/climate-related-risks-and-extreme-events Accessed 16.05.2022.
[2] Kenton, W. (2022). Business risk. Available from: https://www.investopedia.com/terms/b/businessrisk.asp Accessed 16.05.2022.
[3] BCC Research, (2017). Technologies for Assessing Risk Management: Global Markets. Available from: https://www.bccresearch.com/market-research/information-technology/risk-management-market-report.html Accessed 16.05.2022.
[4] BIS, (2021). Climate-related risk drivers and their transmission channels. Available from: https://www.bis.org/bcbs/publ/d517.pdf Accessed 16.05.2022.
[5] Woetzel, et al. (2020). Climate risk and response: Physical hazards and socioeconomic impacts. McKinsey Global Institute. Available from: https://www.mckinsey.com/business-functions/sustainability/our-insights/climate-risk-and-response-physical-hazards-and-socioeconomic-impacts Accessed 16.05.2022.
[6] Koch, C. (2021). Why companies should pay attention to climate change proposals. Ernst & Young. Available from: https://www.ey.com/en_nl/tax/why-companies-should-pay-attention-to-climate-change-proposals Accessed 16.05.2022.
[7] Buosso, et al. (2021). Shell ordered to deepen carbon cuts in landmark Dutch climate case. Available from: https://www.reuters.com/business/sustainable-business/dutch-court-orders-shell-set-tougher-climate-targets-2021-05-26/ Accessed 16.05.2022.
[8] Bank of England, (2019). Climate change: what are the risks to financial stability. Available from: https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability Accessed 16.05.2022.
[9] Donovan, C. (2018). Opinion: There is no such thing as climate risk. Available from: https://realassets.ipe.com/sustainability/opinion-theres-no-such-thing-as-climate-risk/10024563.article Accessed 16.05.2022.