Understanding Climate Risk Assessment

1. Why assess climate risks?

Climate change is one of the most pressing challenges we currently face. From extreme weather conditions to slower on-set events such as ocean acidification, desertification, and biodiversity loss, climate change implies a series of physical and transition risks that could translate to financial losses. Hence, assessing climate-related risks is crucial for both businesses and financial institutions for achieving resilience and long-term growth.

Climate risk assessment enables an understanding of how physical and transition risks and opportunities might plausibly impact the business or investment (strategies and financial performance) over time, and how such vulnerabilities should be addressed.

The assessment can be used to inform a range of decisions, including:

• Development of adaptation and mitigation strategies,
• Identification of potential investments and business opportunities, and
• Development of risk management plans.

2. Understanding Climate-related Risks

2.1 Physical and transition risks

Climate risk assessment refers to the assessment of the exposure of businesses and investments to climate-related risks. This assessment takes into account both physical and transition risks, as well as the potential consequences of these risks.

According to the TCFD, physical risks refer to the risks of financial losses caused by climate change-induced extreme weather events while transition risks refer to the risk of policy, law, technological, and market changes brought about by the low-carbon economy. The following table excerpted from a TFCD workshop summarises a list of examples of physical and transition risks.

Different risks imply different potential financial impacts on businesses and investments. To name a few:

• Transition risks from emissions-reporting regulations could mean increasing operating costs arising from replacing existing assets with carbon-neutral options.
• Transition market risks from changing customer preference / behaviour could imply reduced demand for certain products while rising cost of raw materials could increase production costs. Altogether this might mean a change in revenue mix and call for the repricing of assets (such as fossil fuel reserves, land and securities valuations).
• Physical risks from extreme weather conditions or changes in precipitation patterns could lower asset valuations, cause write-offs or early retirement of existing assets.

2.2 Orderly and Disorderly Transition

Research shows that physical and transition risks would vary under different temperature rise scenarios. Although lower temperature rise scenarios and hence more ambitious temperature targets could imply more transition risks, the UNEP indicates that the level of transition risks experienced should also depend on whether the transition is orderly or disorderly.

According to NGFS, orderly transition means climate policies are introduced early and gradually become more stringent, while disorderly transition means climate policies are delayed or divergent across regions. In general, the more orderly the transition to a low-carbon economy, the lower the level of transition risks become.

3. The process of climate risk assessment

3.1 Step 1: Identify and prioritize material climate-related risks and opportunities

The climate risk assessment process typically begins with first identifying climate-related risk exposures, followed by prioritizing those risks and opportunities that are material. This can be done via:

1. Definition of scope, parameters, indicators of acute and chronic, physical and transition risks/opportunities.
2. Definition of data needs catering for the defined scope and parameters, for effective risk assessment.
3. Data collection and stakeholder engagement for the identification of the impact of climate-related risks and opportunities on the company’s strategy and financial planning. This should be done to enable materiality assessment (read more about materiality assessment).
4. Data analysis for prioritizing material climate-related risks based on severity (scope, scale, irremediable character) and likelihood.
5. Building upon promising opportunities, such as access to new markets with the development or expansion of low-emission products/services.

3.2 Step 2: Climate Scenario Analysis

Scenario analysis is a process for identifying and assessing a potential range of outcomes of future possible events under conditions of uncertainty. Climate scenario analysis forms part c) of the ‘Strategy’ TCFD recommendation related to disclosing resilience. It is used for businesses and investors to assess resilience to climate-related risks and serves as a basis for continuous monitoring and strategy adjustment.

Climate scenario analysis involves:

• Testing a strategy / strategy options against a set of hypothetical scenarios
• Identifying possible future threats / opportunities
• Identifying signposts to set contingency plans in motion
• Focal questions in terms of ‘what would happen to the enterprise / investment should x (physical or transition risks) happens’,
• Driving forces of the scenarios
• Critical uncertainties
• Scenario narratives
• Implications from scenarios and options available–including business / investment impacts and potential responses
• Indicators and signposts for determining an optimal response strategy

The following figure from the TFCD technical supplement on scenario analysis shows a step-by-step guide to carrying out climate scenario analysis.

Step 3: Develop an action plan to mitigate risks

Depending on the severity and likelihood of risks; scale, scope, and likelihood of opportunities, the approach to address risks/opportunities vary. According to the GRI Standards, an organization should address potential negative impacts through prevention or mitigating actions. Whereas actual negative impacts caused or contributed to by an organization should be addressed via remediation by that organization.

Upon deciding on which preventive / mitigating / remedial actions should be taken, the key actors involved in implementing these actions must be identified, e.g. which sub-division or region.

Then a timeline for action implementation that reflects both the severity and risk nature needs to be developed. Priorities should be given to actions that address more severe or urgent risks whereas long and medium-term action plans may be required for addressing chronic physical risks.

Upon considering the key actors and timeframe, the costs and benefits of implementing the action plans need to be assessed before resources are deployed.

To go one step further, success factors that facilitate the implementation of the action plan can be considered. For example, by considering what might increase stakeholder acceptance.