What is Climate Risk: Understanding Physical & Transition Risks

As the effects of climate change hit home with organizations, investors, and stakeholders, it is becoming ever clearer that climate risk is financial risk. The climate crisis poses a host of different risks to the financial stability of all organizations. These risks fall under two main categories: physical risks and transition risks.

In this article, we delve into the definition of climate risk, explore its various types, examine its implications across different sectors, and discuss strategies for managing and mitigating it.

What is Climate Risk?

Climate risk refers to the potential financial, social, or environmental harm caused by climate change. It encompasses a range of hazards, from extreme weather events to longer-term shifts in climate patterns. This risk can materialize in diverse ways, affecting businesses, supply chains, infrastructure, investments, and the economy at large. Understanding climate risk is crucial for developing effective strategies to mitigate its impacts and build resilience in the face of a changing climate.

Types of Climate Risk

There are two types of climate-related risks: physical risks and transition risks. We dive into each of these below.

Physical Risks: The Tangible Impacts

Physical risks are the more ‘obvious’ climate-related financial risks. They refer to the economic ramifications of damage to infrastructure, supply chains, and the built environment. We know climate change will place these systems under immense strain. And as we see increasing weather disasters, sea-level rise, flooding & extreme heat, water shortage, and climate migration, business won’t be able to continue as usual.

Although all large companies will be affected by the physical risks of climate change to some degree, certain geographies are more susceptible than others. Oil and gas companies with rigs in the Gulf of Mexico, for example, will suffer longer periods of inactivity due to more frequent and unpredictable hurricanes. In much the same way, organizations with headquarters in Manhattan or Miami will be subject to recurrent flooding events as sea level rises.

To prepare for the physical risks of climate change, organizations must conduct climate risk assessments. These should involve projection modeling of a range of possible scenarios to assess how future weather events, sea level rises, droughts etc. will affect the operations of an organization.

Nevertheless, some of these risks will be unavoidable. Adaptation will be required to reduce incurring financial loss and protect companies’ chances of survival. Adaptation strategies could include making long-term plans to diversify suppliers and supply chain routes, as well as moving operations from high-risk areas.

Transition Risks: The Shifting Terrain

Transition risks are those related to the process of transitioning away from reliance on fossil fuels and toward a low-carbon economy. Examples of these risks include the possible implementation of a carbon tax, carbon disclosure mandates, or the transition to renewable energies.

Although all companies will be affected and should assess their transition risk, some industries will be hit significantly harder than others. For instance, the oil and gas sector is particularly likely to face a stiff transition risk– especially as fossil fuels are phased out in line with climate goals. Moreover, oil and gas increasingly face litigation from NGO’s and members of the public for not performing a duty of care on the climate change issue.  Similarly, the automotive sector is also prone to face transition risks as the world moves to electric vehicles.

With recent national regulations such as the SEC’s climate disclosure rule (and other similar rulings in the UK, Japan, and New Zealand), large publicly traded companies will soon be mandated to assess their physical and transition risks in line with how they assess and plan for other potential financial risks. This only further increases the transition risks for companies under these jurisdictions— they will be audited against their claims and could face litigation.

Implications of Climate Risk Across Sectors

Climate risk has far-reaching implications across various sectors, encompassing economic, social, and environmental dimensions. Listed below are a few examples of impacts of climate risk.‍

• ‍Agriculture and Food Security: Changing weather patterns, extreme temperatures, and water scarcity pose significant challenges to agricultural productivity and food security. Crop failures, livestock losses, and reduced yields can lead to food shortages, price volatility, and increased vulnerability among farming communities. Additionally, shifts in growing seasons and pest infestations further exacerbate the risks faced by farmers.
• Energy: Shifts in temperature and precipitation patterns can affect energy production and distribution. Hydropower generation may decline due to reduced water availability, while extreme weather events can damage energy infrastructure, leading to power outages and supply disruptions.
• ‍Infrastructure: Infrastructure systems are vulnerable to climate-related hazards such as floods, storms, heatwaves, and sea-level rise. Aging infrastructure, inadequate planning, and insufficient investment in resilience measures increase the likelihood of damage and disruptions. For example, urban areas are at risk of flooding due to inadequate drainage systems and impermeable surfaces, while coastal communities face threats from storm surges and erosion.‍
• Finance and Investments: The financial sector is exposed to climate risk through investments in carbon-intensive industries, fossil fuel assets, and vulnerable regions. As the physical and transitional impacts of climate change become more pronounced, there is growing concern about the value of these investments and the potential for stranded assets. Additionally, climate-related disasters and liabilities can have ripple effects throughout the global economy, affecting insurance markets, capital flows, and investor confidence.‍
• Health: Climate change has significant implications for human health, including heat-related illnesses, respiratory problems, vector-borne diseases, and mental health issues. Extreme temperatures, air pollution, and disruptions to ecosystems can exacerbate existing health disparities and increase the burden on healthcare systems. Vulnerable populations, such as the elderly, children, and low-income communities, are particularly at risk.
• Transportation: Extreme weather events and sea-level rise can disrupt transportation networks, including roads, railways, ports, and airports. This leads to delays, increased maintenance costs, and challenges in ensuring the resilience of transportation infrastructure.
• Tourism and Recreation: Climate change impacts natural landscapes and ecosystems, affecting tourism and recreation activities. Coastal erosion, coral reef degradation, and loss of biodiversity diminish the attractiveness of destinations, leading to revenue losses for businesses dependent on tourism.
• Biodiversity: Biodiversity loss and ecosystem degradation are direct consequences of climate change and pose threats to global ecosystems and species survival. Habitat destruction, species extinction, and ecosystem collapse disrupt ecosystem services such as pollination, soil fertility, and water purification, with cascading effects on human well-being. Conservation efforts and ecosystem restoration are critical for preserving biodiversity and building resilience to climate change.

Climate Risk Management

Climate risk management involves the identification, assessment, and mitigation of potential risks and vulnerabilities associated with climate change. It encompasses a range of strategies and actions aimed at reducing the adverse impacts of climate-related hazards on human systems, ecosystems, and economies.

Key Components of Climate Risk Management:

1. Risk Identification: The first step in climate risk management is identifying and understanding the specific risks and vulnerabilities posed by climate change. This involves conducting comprehensive assessments of current and future climate-related hazards, such as extreme weather events, sea-level rise, temperature fluctuations, and changes in precipitation patterns. Stakeholder engagement and collaboration are essential for gathering diverse perspectives and insights into local climate risks.
2. Risk Assessment: Once climate risks have been identified, they must be assessed to understand their potential impacts and likelihood of occurrence. Risk assessments involve analyzing the exposure, sensitivity, and adaptive capacity of vulnerable systems and populations to climate-related hazards. This process helps prioritize risks based on their severity and urgency, allowing for targeted interventions and resource allocation.
3. Risk Mitigation: Mitigating climate risks involves implementing measures to reduce the likelihood and severity of adverse impacts. This may include implementing structural and non-structural measures to enhance resilience and adaptive capacity in vulnerable areas. Structural measures may include building seawalls, upgrading infrastructure, and implementing green infrastructure solutions such as wetlands restoration and afforestation. Non-structural measures may include land-use planning, zoning regulations, early warning systems, and community-based adaptation initiatives.
4. Adaptation Planning: Climate risk management also involves developing adaptation plans and strategies to prepare for and respond to the impacts of climate change. Adaptation planning encompasses a range of actions, including mainstreaming climate considerations into development planning, integrating climate resilience into sectoral policies and programs, and enhancing adaptive capacity at the community level. Effective adaptation planning requires a multi-sectoral approach, stakeholder engagement, and consideration of long-term climate projections and uncertainties.
5. Monitoring and Evaluation: Climate risk management is an iterative process that requires ongoing monitoring and evaluation to track progress, assess effectiveness, and adjust strategies as needed. Monitoring involves collecting data on climate-related hazards, vulnerabilities, and adaptation actions to inform decision-making and policy development. Evaluation involves assessing the outcomes and impacts of adaptation measures, identifying lessons learned, and identifying areas for improvement. Regular monitoring and evaluation help ensure that climate risk management efforts are effective, efficient, and responsive to changing conditions.

Identifying New Climate Opportunities

Both physical and transition risks should be considered when trying to reduce financial risk. There are, however, also opportunities for investment and innovation in sustainable solutions to these issues. Climate adaptations such as sea wall defenses, desalination, and new agricultural techniques will create many opportunities. The low-carbon transition will also be a huge business opportunity as new technologies in renewable energies, electric vehicles, and energy efficiency drive us to decarbonization.

By assessing climate risk and making changes to mitigate those risks, companies can cut costs, meet the growing sustainable expectations of investors and stakeholders, while improving the reputation of their company as an environmental steward, creating new customers, and attracting and retaining talent.  

Measuring and managing these risks is integral for companies to reduce long-term financial risk. Companies that identify the risks most material to their organizations and act appropriately will be in a better position to manage the challenges climate change will bring.  Those that do not will feel the repercussions – and may “go the way of the dodo”.