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Understanding Climate Risk

Climate risks are essentially the financial risks linked to climate change. Spearheaded initially by the Taskforce on Climate-related Financial Disclosures (TCFD), the delineation of climate risk into two overarching categories—Physical and Transition risks—provides a pivotal framework for understanding the multifaceted challenges ahead.

Physical Risks: These are tangible manifestations of climate risk which can be further classified as either acute or chronic hazards. Acute hazards are weather related events whose incidence are increasing with climate change, such as floods, hurricanes and wildfires. Chronic hazards are gradual, long-term trends such as rising average temperatures and sea levels.

Transition Risks: In parallel, these risks mirror the tectonic shifts required to steer economies towards carbon neutrality. Policy mandates, technological innovations, and evolving consumer preferences serve as the catalysts propelling this transition, while also posing potential disruptions to established industries and practices.

Assessing Exposure and Vulnerability

Central to the comprehension of climate risk lies the concepts of exposure and vulnerability. Just as in credit risk, exposure denotes the susceptibility of assets and companies to climatic hazards and are hence “exposed”, whereas vulnerability is the predisposition to suffer adversely from exposure to hazards. 

Navigating Stranded Assets

Stranded assets are assets that have suffered from unanticipated or premature write-downs, declines in utilisation, devaluations or conversion to liabilities.

Intangible assets can also become stranded such as employee skills and expertise e.g. car mechanics not trained on electric, green cars. The faster the pace of decarbonization, the greater the chance of stranded assets.

Climate Risk is a Transversal Risk

It is important to note that Climate risk is a transversal risk that affects nearly all other traditional categories of risk in some way. It also poses a potential threat to financial stability, constituting a source of systemic risk at the macro level. 

Climate risk, broken down into Physical and Transition Risk, can impact traditional risk categories as illustrated in the examples below:

Operational Risk

Physical risk from extreme weather events can result in property damage, business interruption, supply chain issues, and worker productivity.

Transition risk from policy changes can lead to stranded assets (e.g. facility closures) and people risk from staff inadequately trained in new technologies or processes.

Credit Risk

Physical risk from property damage or business interruption can lead to loss in revenues and profits which can impact a company's ability to service its debts and fulfil obligations.

Transition risk causing asset stranding can severely damage a company’s balance sheet position (e.g. asset write-off) thereby causing an overweight in respective liabilities and increasing probability of default.

Liquidity Risk

Both physical and transition risks can result in sharp repricing of products and market re-evaluations of a company as a going concern. Liquidity impacts result from funding shortages and banks can be particularly prone to this risk with the potential for bank runs on any banks perceived to be in trouble as a result.

Market Risk

Both physical and transition risks can cause severe fluctuations in prices of commodities, shares, bonds etc.  through abrupt repricing or gradual change. This in turn can impact portfolio values and investments.

Insurance Risk

Physical risk can lead to higher insurance premiums or even uninsurable areas/assets. Transition risk can lead to less insurance availability for industries and activities that are being phased out.

What are the main challenges?

1. Regulatory and Reporting Uncertainty

What gets measured, gets managed. However, the industry as a whole is still in its infancy and with numerous reporting standards such as ISSB, GRI, CSRD to name a few, regulators and institutions are still unsure as to which model(s) to adopt and there is still much work to be done to ensure the interoperability of standards. Moreover, regulation ultimately drives risk management practices and implementation for the majority, so the investment, implementation and uptake are reliant on clear and consistent communication.

2. Data Analytics

Effective risk mitigation relies upon robust data analytics, spanning from historical climate trends to real-time asset-level insights. For physical risk, this necessitates a fusion of climatological models, topographical data, and asset locational information, while transition risk demands granular assessments of greenhouse gas emissions alongside policy and technological landscapes.

3. Resources and Skillset

Whilst there is a desire to address climate risk, there is clearly a lack of resource and appropriate skillset to do so given the infancy of field. Furthermore, the breadth of the topic requires dedicated expertise as opposed to an add-on to existing roles.

Conclusion

This article highlights the importance of understanding and managing climate risks—categorised into physical and transition risks—as they increasingly impact traditional risk management practices. It underscores the challenges of regulatory inconsistency, data analytics needs, and skill shortages. Effective management requires integrating climate considerations into decision-making, ensuring regulatory harmony, and improving data accuracy to enhance economic resilience and sustainability.

If you would like to find out more about climate risks and how to mitigate them effectively or about ESG reporting and assurance then please contact Paragon Consulting Partners at [email protected]  or you can reach us on our website at paragonconsulting.partners