What is certain is that climate change will affect every business, to a greater or lesser extent. Losses might occur as a direct cause of extreme weather events, such as storms, droughts or floods, or indirectly, by higher risk of default due to economic and social disruption, litigation risk, reduced returns and falling economic growth – even in case of investments which avoid physical damage. Climate risks affects all economic sectors, however the level and the type of exposure differs by geography, sector, industry and asset and/or credit portfolio of the company.
Why is this important for the NED?
- Understanding how climate change can impact businesses is key for building a robust business case for the integration of climate considerations within the organization’s strategy.
- The Guidance equips the NEDs with the knowledge necessary to bring the climate agenda to the board and sets a high-level mapping of major impacts climate change can have on a company and its financial position in short-, medium-, and long-term.
There is considerable uncertainty about the impacts of climate change on business. It is impossible to assess with certainty how much the temperature will increase globally, which regulatory pathways governments and regulators will pursue and how these change will financially impact different regions, markets, sectors, organisations and their cash flows, as well as societies in general.
What is certain is that climate change will affect every business, to a greater or lesser extent. Losses might occur as a direct cause of extreme weather events, such as storms, droughts or floods, or indirectly, by higher risk of default due to economic and social disruption, litigation risk, reduced returns and falling economic growth – even in case of investments which avoid physical damage. Climate risks affects all economic sectors, however the level and the type of exposure differs by geography, sector, industry and asset and/or credit portfolio of the company. Climate-related risks are particularly acute in sectors that include extraction and combustion of fossil fuel (coal, oil and gas). Other highly affected sectors include financial services, real estate and infrastructure, transport and agriculture.
Climate change has rapidly evolved from an ‘environmental, non-financial’ issue to a mainstream financial risk affecting almost all sectors of the economy. Regulators and investors in developed economies now routinely refer to the Recommendations of the Taskforce on Climate-related Financial Disclosures – a trend that will undoubtedly become relevant in emerging economies.
From the perspective of the NED, it is pivotal to distinguish between two key climate-related business drivers – the company’s impact on climate change, and the impact of climate change on the company. The company’s impact on climate change is dependent on the amount of GHG emissions necessary for its operations. The impact of climate change on the company involves e.g. physical asset impairment due to extreme weather event or worsening of labor conditions due to global temperature rise. Those can be further divided into direct and indirect impact – direct impact involving the company itself, indirect impact involving shocks and disruptions in the supply chain and markets.
Climate-related risks might be classified as physical risks and transformation risks. Physical risks are related to extreme weather events or to the gradual changes that compound over the medium to long term (such as increase in average temperature, changes in precipitation patterns and sea-level rise). Transformation risks relate to the policies and regulatory reforms related to lowering of the emissions, developments in technology in areas such as renewable energy or battery storage, and shifting stakeholder expectations regarding climate action – this refers to regulators, investors and clients in particular.
In addition, there is also a litigation risk that links the two aforementioned types of risks – it constitutes an exposure arising from the attribution of climate change to a company’s activities or a failure to manage either (or both) the physical or economic transformation risks. TCFD has classified litigation risk as a transformation-related risk.
From the perspective of the NED, it is crucial to understand what types of categories of risks and opportunities can impact the financial position of the company. Although, as mentioned before, the impacts vary depending on geography, sector, industry and asset and/or credit portfolio of the company, they can be summed up as follows:
Given the degree of interconnectedness in the economy, it is important to assess both the direct impacts of physical and transformation risks on the company, as well as the indirect effects – transmission of shocks within the supply chain (downstream and upstream).
Translating climate-related risks into plausible financial impacts remains a challenge, mainly due to lack of data, tendency to focus on near-term risks, and the difficulty in quantifying the financial effects of climate change on a company.
The physical risks climate change poses can be categorised as acute or chronic – the former typically event driven and the latter consequences of longer-term shifts in climate patterns. Physical risks can damage property, erode collateral and asset values (majorly impacting insurance liabilities), and disrupt supply chains. The table below provides and overview of physical risks and its potential financial impact, as identified by be TCFD.
Transformation risks are risks associated with actions taken to curb GHG emissions by governments and regulatory bodies. Key factors for assessing transition risk include the magnitude and speed of the transition and the policy instruments used. This will vary across regions and sectors, therefore companies operating in more than one jurisdiction have to take extra precautionary steps and evaluate the level of coordination between environmental and climate laws under which they operate. Simultaneously, companies have to be aware of shifting customer demand and technology risk associated with aligning with the Paris Agreement – both in terms of direct impact, as well as supply chain exposure.
The text is an expert study of publicly available materials for non-executive directors from sectors other than financial services.