Investor Protection: “Climate Risk = Financial Risk”

If the link between climate change and investor protection isn’t immediately clear to you, you are not alone. There are a few intermediate steps between the two that can sometimes be overlooked, so let’s take a closer look.

On the climate side, there is general acceptance and understanding that a changing climate has accelerated the frequency and intensity of weather events, shifted long-term weather patterns, and caused effects such as drought and rising sea levels. These events and trends represent obvious ‘physical climate risk’ that impacts individuals, communities, and businesses.

On the investor side, material trends, events, or circumstances, climate-related or otherwise, that could impact a company’s financial performance must be disclosed in a consistent and comparable manner to investors. This enables investors to make informed decisions about their financial positions. These factors represent ‘financial risk’ impacting companies and, ultimately, their customers, partners, and investors alike.

Now, there is sometimes some hesitation with the assertion that “Climate Risk = Financial Risk”, particularly from companies or industries that might consider themselves relatively unexposed to climate-related events and impacts. Other companies may acknowledge climate change in general but don’t consider it a business risk because their emissions footprint is relatively low.

So, let’s delve a bit deeper into the ways that climate risk can manifest, and the far-reaching financial impacts associated with each.

Climate risk is actually broader than extreme weather events and trends we just mentioned above.  Rather, climate risk can be broken down into two main types: physical risk and transition risk.

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PHYSICAL RISK

First, physical risks refer to the physical impacts of climate change, and can be acute or chronic.

• Acute risks are defined as event-driven risks associated with shorter-term extreme weather events, such as hurricanes, floods, and tornadoes.  
• Chronic risks are defined as those risks faced as a result of long-term changes in weather patterns, including higher temperatures, sea level rise, and drought.

Now, we can start to imagine the financial burdens that accompany these types of physical risks for businesses.

Examples that highlight the financial impact of acute physical climate risks include:

• Small business impact:  A local restaurant needing to rebuild after wind damage from a hurricane 
• Corporate impact:  An airline absorbing the cost of multi-day flight disruptions resulting from the same hurricane
• Indirect corporate impact:  Hundreds of companies suffering productivity losses due to stranded passengers resulting from the aforementioned disruptions

Examples that highlight the financial impact of chronic physical climate risks include:

• Small business impact: a farm producing a shrunken annual crop yield due to now-regular flooding in South Texas
• Corporate impact: A consumer packaged goods (CPG) company relocating their logistics center out of an increasingly flood-prone area
• Indirect corporate impact: Retailers absorbing supply chain inefficiencies due to consistently disrupted or delayed deliveries

From just these simple examples, you can start to extrapolate that the financial impact of physical climate risk can be quite significant for businesses of all types and industries. 

Even if your company seems distant or otherwise shielded from climate impacts, you’re likely not more than 1-2 degrees of separation from feeling an effect, and these impacts are accelerating in frequency and intensity over time due to the cumulative effects of physical climate risk.

TRANSITION RISK

The other type of climate risk is transition risk. While there’s a lengthy definition of transition risk in the SEC rule, it’s often paraphrased as the financial impact of the broader shift to a low-carbon economy.  This shift could include various factors, such as new regulations, changes in market demand, and financing availability.

All of these could directly or indirectly prompt companies to adjust their strategy or business model with specific regard to climate change.

Examples of the financial impact of transition risk include:

• Regulations – the EU approves law to phase out the sale of gas-powered vehicles by 2035, prompting large car manufacturers to invest capital in EV production and convert legacy production assets
• Market demand - consumer spend shows outsized growth rates of products with sustainability-forward claims (e.g. locally sourced, recycled materials, reduced packaging) threatening loss of revenue and market share for companies who don’t produce such products
• Profitability threat - insurers cease issuing policies in areas highly susceptible to physical risk in order to limit exposure to potential losses
• Financing availability - lenders begin to withhold financing from companies with relatively high carbon dependencies, causing companies to secure other financing at less favorable terms, or to invest in new decarbonization efforts

CLIMATE RISK = FINANCIAL RISK

Zooming back out, you should now be able to explain that there is, in fact, a link between climate risk (both physical and transition) and a company’s financial risk, and that this financial risk can be quite significant.

Aggregated impacts of climate change have been forecast to cost $4 trillion of GDP by 2030, with the world’s 215 biggest companies alone reporting ~$1 trillion at risk from climate impacts.  In the US alone, NOAA is seeing a steady increase in the number of billion-dollar events annually related to climate and extreme weather. 

Therein lies the primary intent of the SEC disclosure rule:  to ensure that investors are adequately informed about climate-related risks that could have a significant financial impact on companies in which they invest.