Nowadays, our society is faced serious climate issues such as global warming and sea level rising. Therefore, it’s essential to think about how the climate change can affect our society, the risk drivers behind and the potential economic and financial impact, and how can we response to this. We also use case study to explain the impacts in detail.
Introduction of climate risk
There are Two types of climate risk: transition risk and physical risk. Transition risks are business-related risks that follow societal and economic shifts toward a low-carbon and more climate-friendly future. These risks can include policy and regulatory risks, technological risks, market risks, reputational risks, and legal risks. These risks are interconnected and often top of mind for investors as they attempt to navigate an increasingly aggressive low-carbon agenda that can create capital and operational consequences to their assets. For asset managers and investors alike, estimating the overall transition risk associated with a portfolio can be a daunting task.
Physical Risks are typically defined as risks which arise from the physical effects of climate change and environmental degradation.They can be categorised either as acute - if they arise from climate and weather-related events and an acute destruction of the environment, or chronic - if they arise from progressive shifts in climate and weather patterns or a gradual loss of ecosystem services which can benefit humans or enhance social welfare.
All climate scenarios are expected to have some of both:
High transition risk and moderate physical risk due to drastic emission reduction (e.g. limit global warming to 1.5-2 °C )
Continued emissions due to inaction could result in up to 6°C of global warming and thus high physical risk
Trade-off between transition and physical risk
Figure1. Relationship between transition and physical risk
Scenario analysis is a frequently used method in climate risk measurement. Here, we give a brief explanation about how companies are using scenario analysis to measure each type of climate risks.
Transition risk: Corporates can exam the impact of different degrees of climate policies assuming different degree of climate risk our society are exposed to in future.
Physical risk: Use physical climate scenarios (e.g. IPCC) to measure the physical risk exposure of their operations and assets to climate hazards
Risk drivers and corresponding climate risks
It’s worth to think about which factors are more likely to lead to climate risk if we want to reduce the impact on society. Therefore, we give some examples of different risk drivers for both physical risk and transition risk.
Physical risk drivers
Acute physical risk drivers
Acute physical risks are generally considered to consist of: lethal heatwaves, floods, wildfires and storms, including hurricanes, cyclones and typhoons as well as extreme precipitation.
Figure 2. 3 billion animals impacted by Australia’s bushfire crisis, WWF
Chronic physical risk drivers
Chronic physical risks are generally considered to include: rising sea levels, rising average temperatures, and ocean acidification. Extended periods of increased temperatures may lead to the further development of chronic climate events, such as desertification. Similarly, extended periods of increased average temperatures might impact the ecosystem, agriculture in particular.
Figure 3. Rising sea levels threaten 200,000 England properties, BBC
Physical risks and geographical heterogeneity
Climate change is a global phenomenon, but the way in which physical risks impact economies will vary depending on geographical location as different regions exhibit distinct climate patterns and levels of development. Some regions like Venice are therefore expected to be more severely affected than others because they are more exposed and also more vulnerable to specific types of weather disasters.
Figure 4. 65% of Antarctica’s plants and animals could disappear, scientists say. Its iconic penguins are most at risk, CNN
Transition risk drivers
1. Climate policies
As part of the Paris Agreement, the parties agreed to take measures to curb GHG emissions through energy transition policies, pollution control regulation, policies on resource conservation, and public subsidies
2. Technology
Technological change relating to energy-saving, low-carbon transportation, and increasing use of non-fossil fuels or other technologies that help reduce GHG emissions are needed to meet policy goals. However, corporates’ existing technologies may be not very environmental-friendly, leading to higher costs as a result of policy measures such as carbon tax. This creates a need for them to adapt to minimise the downside impact and to remain competitive.
3. Investor sentiment
Equity and debt investor awareness and expectations with respect to climate change are increasing. A growing number of investors are incorporating climate risk considerations into their investment decisions, potentially reflecting growing pressure from non-governmental associations and environmental groups. See below as an example of how climate risk is affecting oil & gas company’s executive decision!
4. Consumer sentiment
A change in human behaviour is required to transition to an economy with lower carbon emissions. A shift in behaviour to climate-friendly consumption would, for example, create a move to more climate-friendly transportation, manufacturing and energy use.
Oil & Gas Case study
Here, we use a diagram to clearly display how climate risk can affect an oil & gas company’s financial statements.
Firstly, the company can calculate its oil production through the historical series of production, standard production profiles and assumptions including decline rates, finding and development costs, undiscovered oil and reserved growth; and predict consumptions by some existing models. Then, the price of energy is determined by the demand and supply. According to IEA scenarios, carbon price is established in all advanced economies, and several developing economies are also put in place schemes to limited CO2 emissions. Then, we can adjust costs caused by climate factors such as carbon price, costs due to investment and transition to new technologies; and reflect climate-related risks from financial statement (e.g. impact on impairment, fair valuation, provisions). Finally, we can predict the cash flow, revenue and EBITDA to assess the company’s performance
References:
2020 TFCD Guidance on Scenario Analysis
Climate-related risk drivers and their transmission channels, Basel Committee on Banking Supervision
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