What is climate risk?

What is climate risk?

Until very recently climate change was seen as a “future problem”. This has changed. The world is experiencing the physical impacts on climate change already today: more extreme downpours, droughts, record heat, it is all part of the same phenomenon. The policy response to climate change has been felt already for many years, and is accelerating with regulatory shifts such as the ECB Guide on Climate-Related and Environmental Risks, and the EU Taxonomy. Climate change is the main driver behind this megatrend. Yet, companies struggle to respond, due to lack of understanding of how climate presents as a material risk to financial stability and financial performance.

Climate risk can be categorized into Physical or Transition Risks.

Physical Risks

Resulting from climate change can be event driven (acute) or longer-term shifts (chronic) in climate patterns. Categories of physical risk include: pluvial (rainfall) flooding, fluvial (coastal) flooding, heat/cold stress, water stress, wildfire, and extreme weather events (storms). Acute physical risks may have financial implications such as direct damage to assets and indirect impacts through supply chain disruption. Financial performance may also be affected by chronic changes in water availability, sourcing, and quality; or, temperature changes reducing productivity and impacting employee safety.

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Transition Risks

May entail extensive policy, legal, technology, and market changes to address mitigation and adaptation requirements related to climate change as global systems shifts towards a green and low-carbon economy. The risks arising from these changes can be categorized into policy & regulatory, technology, market, and reputational. Depending on the nature, speed, and focus of these changes, and the unique context of the company within supply chains and markets, transition risks pose varying levels of financial, regulatory, and reputational risk to organizations. Transition risks can also be event driven (acute) such as policy shocks or carbon pricing shocks, or longer-term shifts (chronic) such as increasing regulatory requirements for climate-related disclosures.

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Business Drivers

Both physical and transition risk categories can represent material risks and opportunities to financial market players and operating companies. These can include:

Strategy Objectives – Business models and strategies require innovation to remain competitive; climate brings another factor to understand risk exposure or potential for opportunity realisation.

Operational Performance – Supply chain disruptions, employee management, and ability to deliver can be put at risk, or be exposed to opportunities.

Financial Management – Unexpected expenditures, impacts on revenue, or a shifting landscape for access to capital can impact how corporate finances are managed.

Reputation & Stakeholder Engagement – Increasing regulatory requirements are coming into force many governments are following through on their emissions-reduction pledges. Social and corporate awareness of climate change are increasing, and these trends are increasingly driving changes in behaviour including climate-related litigation.

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