With the very welcome and intensifying public interest in climate change and the risks it presents to businesses large and small, we have received numerous questions covering the entire spectrum of climate-related risks. This piece was developed to facilitate and expedite understanding of climate change and climate-related risks, intended for those seeking an entry-level understanding of the subject for their business needs or those with a general interest in the subject.
Weather, climate, climate change and global warming
Weather typically describes the meteorological conditions at a point in time, at a specific place, or region. For example, if it’s raining outside today, that’s a way to describe today’s weather. Other weather events include sunshine, wind, snow, hurricanes, and tornadoes.
Climate is more than just one or two rainy days. Climate describes the weather conditions that are expected in at a specific place or region, at a particular time of year.
Climate change is a change in the patterns of weather, such as temperature or rainfall, at a place or region over a long period of time. Climate change also includes changes in oceans, land surfaces, shrinking mountain glaciers, accelerating ice melt in Antarctica and the Arctic, and shifts in flower and plant blooming times and agricultural cycles, occurring over decades or even longer.
Scientists at NASA and other august scientific institutions have observed a warming of the earth’s surface. The recent report from the Intergovernmental Panel on Climate Change (IPCC) published in August 2021, included the following highlights:
- ‘Unequivocal’ evidence that human influence has warmed the atmosphere, the oceans, and the land
- Widespread, rapid, and intensifying climate change
- Sea-level rises and other changes that are irreversible
The science is very compelling and the report provides a solid fact base for those interested or those who may be faced with climate science deniers.
See our article, A Reaction To The IPCC Report On Climate Change.
Global temperature records show a well-documented rise since the early 20th century. Of particular concern, these temperature increases have been accelerating in very recent years, since the late 1980s.
Global temperatures are rising and are now at their highest since records began. The 20 warmest years on record have been in the past 22 years. Much of the increased global temperatures have been absorbed by the oceans where we see rising ocean-surface temperatures which have led to an increased frequency and intensity of extreme weather events. (April, 2020)
Climate change and global warming
The terms climate change and global warming are often used interchangeably. “Global warming” is one aspect of “climate change”, caused by the burning of fossil fuels and their emission of heat-trapping greenhouse gases (GHGs) into the atmosphere, and refers to the long-term warming of the earth. Greenhouse gases in the atmosphere trap heat like the glass roof of a greenhouse.
Global warming is caused by increased GHG emissions in the atmosphere
Burning fossil fuels emits heat-trapping gases into the atmosphere, including carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O) and fluorinated gases. While carbon-dioxide represents around 80% of these gases, methane represents only 10%, but is 84 times more potent than carbon dioxide in damaging the atmosphere. This explains the increased focus on regulating methane flares.
The more fossil fuels we burn, the more heat-trapping gases are emitted, increasing the level of warming. The level of emissions is measured in carbon-dioxide equivalent parts per million (CO2 e ppm) and the higher the level of emissions, the more the earth will continue to warm.
For more than 800,000 years, carbon-dioxide equivalent (CO2 e ppm) levels in the atmosphere have ranged between 200-300 parts per million (ppm). Today, that same number sits around 414 ppm and increasing. The last time CO2 e ppm levels were at similar levels, the earth was more than 3°C warmer and average sea-levels were 50 feet higher.
This helps us understand the urgency of the situation and the critical need to move fast to reduce our GHG emissions and therefore the level of warming. It also reinforces the urgent need to transition to a low carbon economy, however, this transition needs careful consideration and planning to avoid shocks such as we are currently seeing in the price and availability of energy.
If 2021 has given us a preview of the impact of a 1.1°C warmer world, just stop and think about what a 3°C warming or anything close to that might be like!
What is the Paris Agreement and what is the significance of the 1.5°C?
The Paris Agreement calls for the world to ensure that global temperatures do not exceed 1.5°C above pre-industrial levels by 2050. 1.5°C is the threshold that scientists consider to be the upper limit to avoid the worst impacts of climate change. To achieve this, global emissions need to be reduced from 1990 levels by around 50% and then by 100%, by the year 2050.
Today, the Earth is about 1.1°C warmer than it was during the 1800s and we are not on track to meet the Paris Agreement. Even with the recently submitted Nationally Declared Commitments (NDCs), it seems unlikely, if not impossible, to achieve the 1.5°C (NDCs are estimates submitted by country governments of their commitment to reduce GHG emissions within the next several years). In fact, some recent estimates suggest that, continuing unchecked, global temperatures could exceed more than 3°C above pre-industrial levels.
The faster we act to reduce emissions, the sooner we will realize these reductions. However, we should be mindful that a certain level of emissions (and therefore warming) is already locked in.
Climate-related risks
What are climate-related risks?
Climate-related financial risks, or climate risks, are the financial risks linked to climate change. Climate risks can affect balance sheets and lead to losses through standard channels such as increased costs, diminished asset valuations or increased loan defaults. Climate-related risks are typically classified as either Physical or Transition risks and organizations need to consider the range of climate-related risks they could be exposed within each of these categories.
Physical risks
Physical risks are those related to the physical impacts of climate change such as increased frequency and severity of extreme weather events (e.g., wildfires, cyclones, hurricanes, floods). Physical risks can lead to:
- Disruption to your business
- Heightened levels of operational risks in your business
- Damage to your physical assets
- Failures in the transportation system(s) which can impact your business
- Disruption to the supply chain which can impact your business
Transition risks
Transition risks are those risks related to the transition to a lower-carbon economy such as the introduction of a carbon tax, increased regulations, heightened permitting requirements and increased exposure to lawsuits.
Transition risks can lead to:
- Policy-driven increased costs (e.g., carbon tax) which can significantly alter the underlying economics of the business and force changes to your business model.
- Liability driven increased costs (e.g., from increased lawsuits)
- Market-driven demand reductions (e.g., from consumer demand)
- Technology-driven risks (e.g., from stranded assets resulting from the introduction of new technologies).
Why are climate-related risks important?
Climate change is a source of significant risk to global financial stability…. and the numbers are increasing fast.
In 2019, the Organization for Economic Co-operation and Development (OECD) stated that, with no further mitigation actions, global temperature rises of 1.5-4°C may lower global real GDP by 1.0-3.3% by 2060 and by 2-10% by 2100. Even at the lower end of estimates, this represents trillions of dollars.
While the OECD statement has merit, I believe that the stated impacts on real GDP are significantly understated and I would suggest the impacts are much closer to those recently cited by Phillip Hildebrand, Vice Chairman, Blackrock. In a recent interview, he suggested that ignoring the impacts of climate change may cost the global economy 25% of GDP over the next couple of decades. Talking about the transition to the low-carbon economy, Hildebrand described the transition as “the most significant reallocation of capital in history, … If you ignore it, you would do so at your peril”.
The point is, given that global GDP in 2021 will be around $94 Trillion, whether it is 2% or 25% of global GDP, the numbers are enormous. And that is just for one year!
Central banks and financial regulators around the world recognize that climate change is a source of risk to the stability of the global financial system. They also agree that the pricing of climate-related risk with its specific challenges (including lack of relevant historical information, nonlinear nature, and long-term characteristics) is a challenge for corporations, financial institutions, and the financial markets.
Accordingly, there is a need for better data as well as new disclosures to better understand and manage these climate-related risks. As transverse risks, climate-related risks will manifest themselves through recognized risk channels or risk types.
Who is exposed to climate-related risks?
We are all exposed to climate-related risks.
Individuals, households, small businesses, large business, organizations, governments, and countries large and small are all exposed to climate-related risks. Clearly, living in or near an area prone to fire risk or subject to flooding or exposed to increased sea-levels carries increased exposure and vulnerability to physical risks.
2021 provided a noteworthy range of examples of climate change and how it is accelerating in frequency and intensity. It also provided some insights into the range of possible impacts from these extreme weather events. From the record temperatures and wildfires in the northwest of the USA and in southern Europe, to the devastating floods in Germany or the terrifying scenes of flooded subways in China, to the wildfires in Siberia and the consequential acceleration of the permafrost.
For some time now, scientists have been ringing the alarm that this would happen, however, some are now suggesting that this is happening faster than initially predicted. Did the subway riders in China think that they would be exposed to climate-related risks while riding the subway?
All businesses, global and local, are and will continue to be impacted by climate-related risks, either directly, indirectly, or both. The most likely scenario is that Transition risks will be significantly larger than Physical risks in the short term (10-15 years), reaching somewhat of an equilibrium over the medium term (10-20 years), and then rebalancing where we see Physical risks significantly larger in the longer term (20-50 years).
Climate risk and the global financial system
The global financial system is critical in managing climate change for several reasons.
Firstly, the financial system touches every business in every sector in some way. For example, it can provide insight into which banks are funding companies operating in high GHG emission industries, and which companies have investments, holdings, or partnerships in GHG sensitive industries, and which insurers are underwriting or investing in companies that are exposed to climate-related risks, whether they be physical, transitional or liability risks.
These institutions, as participants in the global financial system, are uniquely placed to identify, control, manage, and record climate-related risks. Central banks, regulators and supervisors also play a key role in the global financial system. As climate-related risks represent a financial risk, central banks and supervisors need to ensure that the financial system is resilient to these risks.
How climate-related risks impacts banks and other finance industry participants?
And for the banks, insurers and other entities and institutions regulated by central banks, they themselves must also be climate-resilient. Banks need to understand the GHG emissions within their loan portfolio (financed emissions). They also need to understand their customer’s exposures to both physical and transition risks as, without such an understanding, their risk assessment is incomplete. Therefore, although a transverse risk, climate-related risks need to be considered as integral to the overall risk management at the institution.
How do we assess, manage, and reduce climate-related risk?
A key directive of the G20 group of countries is that material climate-related risks be disclosed in a comparable, consistent, and decision-useful manner so that investors have clear visibility about where their money is invested.
Risk frameworks have been developed to help organizations approach their climate-related risk assessment and disclosure requirements. The framework most widely used and recognized, and most likely to be adopted as the global standard, comes from the Task Force on Climate-related Financial Disclosure (TCFD, 2017).
TCFD presents its framework across the four areas of Governance, Strategy, Risk Management, and Metrics and Targets. Delivered in 2017, it addresses all organizations and provides a tailored framework for some of the key sectors within the Financial Industry addressing some of the questions pertinent to that industry. For example:
- Banks: Do you have appropriate insight into the GHG emissions you are financing through your loan portfolio? Do you understand your customers’ physical and transition risks and the financial exposure related to these risks?
- Insurers: Do you have insight into the physical and transition risks related to the policies you are underwriting for businesses?
- Asset Owners: Do they have visibility into the climate-related risks in your portfolio holdings? Prior to an acquisition, do you fully understand the climate-related risks inherent in the business you are acquiring?
- Asset Managers: Does your board engage on climate-related issues? Have climate-related risks been integrated into the overall enterprise risk analysis?
Where to start in understanding and managing your climate-related risks?
1. Consider Calculating Your Carbon Footprint
Calculating your carbon footprint establishes a baseline of your GHG emissions which will help as you develop your plan to reduce your carbon emissions. By lowering your carbon footprint, you can help contribute to the overall reduction in greenhouse gas emissions. To achieve growth in the economy while reducing carbon emissions, a decoupling between the two is needed. This means we need to grow the economy and grow business without a corresponding increase in growth of our carbon emissions.
2. Review Your Exposure to Physical and Transition Risks
All organizations should review their exposure to both Physical and Transition risks. Remember, Transition risks are those related to the transition to a lower-carbon economy such as the introduction of a carbon tax, increased regulations, heightened permitting requirements and increased exposure to lawsuits. There are known, identified industries that, given the nature of their operation, have increased exposure to transition risks. These are known as GHG Sensitive Industries and include:
GHG Sensitive Industries
Energy
| Coal |
| Oil & Gas |
| Electric Utilities |
Transportation
| Air Freight |
| Passenger Air |
| Transportation |
| Maritime Transportation |
| Rail Transportation |
Materials & Buildings
| Metals & Mining |
| Chemicals |
| Construction Materials |
| Real Estate Management & Development |
Agriculture Food & Forestry
| Beverages |
| Agriculture |
| Packaged Foods & Meats |
| Paper & Forest Products |
Infographic by www.esgriskguard.com
These GHG sensitive industries have a higher exposure and vulnerability to transition risks and therefore require higher levels of scrutiny when assessing their underlying climate-related risks.
While your organization may not be classified in one of the GHG Sensitive Industries, you may rely on suppliers within these industries, or you may sell to companies in one of the GHG Sensitive categories. Or, you may have business arrangements or interests in (including holdings in investments in, contracts with, or loans to) businesses in these categories.
3. Consider Developing Your Science-Based Targets / Net Zero Plans
What Are Science Based Targets?
These are GHG emission-reduction targets adopted by companies to reduce GHG emissions and are considered “science-based” if they are aligned with the level of decarbonization required to keep the global temperature increase below 2°C compared to pre-industrial temperatures, as described by the Intergovernmental Panel on Climate Change (IPCC).
For a company to sign up to a science-based target, it needs to establish its own carbon footprint incorporating Scope 1, 2 and most likely, Scope 3 emissions.
What are Scope 1, 2 and 3 Emissions?
Scope 1 emissions are those that come from company-owned or controlled sources.
Scope 2 emissions are those that arise from the generation of purchased electricity, steam, heating, and cooling consumed by the reporting company.
Scope 3 includes all other indirect emissions that occur in a company’s value chain and are the result of activities from assets not owned or controlled by the reporting organization, and that indirectly impacts its value chain, including all sources not within an organization’s scope 1 and 2 boundaries.
Scope 3 emissions are usually the greatest share of the carbon footprint, covering emissions associated with purchasing, raw materials, business travel, waste and water, investments, and product disposal.
Net Zero Plans are inherently linked to Transition plans as they help to demonstrate the delinking between the company’s growth plan and its dependence on fossil fuels for that growth. This helps ensure that the focus is on emissions intensity (e.g., the GHG emissions per dollar of sales or per dollar of revenue).
As mentioned in the opening, this piece was developed to facilitate and expedite understanding of climate change and climate-related risks, intended for those seeking an entry-level understanding of the subject for their business needs or those with a general interest in the subject. Hopefully, this has helped develop your understanding of this very important subject. When it comes to climate change and climate-related risks, there are multiple avenues that can be pursued, however, it always helps to know where you want to go, and if you are unsure, then best to ask for directions.
