What is Climate Risk, and Why Companies Should Act Now To Assess Their Exposure

2023 was the hottest year on record; it was also the year when the US had the most $ 1 billion-plus climate-related natural disasters. As climate risks accumulate, companies need to be prepared to identify, manage, and mitigate these risks to avoid financial exposure.

It isn’t just the physical risks that companies have to worry about – in the coming years, thousands of companies will become subject to legislation, like California’s SB 261 and SEC regulation, which will mandate them to report on climate risks facing their business.

Climate risk has never been more pressing, and identifying and assessing risks has become essential. Not just from a future risk mitigation perspective, but to ensure that your company is prepared to meet upcoming reporting regulations.

Here, we introduce how climate risks are defined, why now is the most important time to start assessing them, and how to prepare your company for any climate risks and climate risk-related reporting you may face.

What is Climate Risk?

Climate risks are any climate-related risks companies face that could impact their financial performance. The International Sustainability Standards Board (ISSB) divides climate risks into two main buckets: the climate risks that arise from the transition to a lower-carbon economy, which are typically policy-driven, legal, technology, and market-related (transition risks), and climate risks that originate from the physical impacts of climate change (physical risks).

What are Physical Risks?

Physical climate risks are the risks that accumulate as a result of a warming planet. These include things like increased wildfires, rising sea levels, and more frequent and severe extreme weather events, including severe cold weather patterns. Physical risks are further divided into acute and chronic physical risks.

  • Acute Physical Risks: Acute risks refer to climate-related events that can happen immediately at any time; these can include wildfires, floods, hurricanes, droughts, etc. They are one-off events that can disrupt supply chains or destroy company property or even prevent essential employees from accessing workspaces.
  • Chronic Physical Risks: Chronic risks refer to the longer-term effects of climate change, such as rising sea levels, biodiversity loss, climate migration, etc., which could have a more profound effect on the global economy and the way companies operate.

What are Transitional Risks?

Transition risks refer to the risks related to the transition to a low-carbon economy. They include things like new climate regulations, greenwashing risks, stranded oil and gas assets, consumer preferences changing, etc., and are divided into four main categories:

  • Policy and Legal Risks: A whole host of new regulations coming into play around the world are or soon will ensure that companies are identifying and reporting their climate risks. In the US, California recently released the California Climate Accountability Package, which will require companies to report on their carbon footprint and climate risks. Additionally, the number of climate litigation cases grows every year.
  • Market Risks: As the global energy systems transition away from fossil fuels, certain asset values could be affected; companies that have investments in fossil fuel assets may find that these assets depreciate or become stranded.
  • Technological Risks: Some existing technologies risk becoming obsolete or being replaced by more efficient technologies. Companies with existing fossil fuel-based technologies should consider innovation. For example, the increase in EV adoption makes this a risky time to enter the spark plug or muffler business.
  • Reputation Risks: Companies’ reputations are increasingly hinging on their climate performance. Consumers, investors, and the public are becoming increasingly aware of companies’ environmental performance. Companies that have been found to mislead or misstate their climate credentials (greenwash) have suffered greatly from a drop in consumer trust.

Understanding Climate Risk Drivers, Transmission Channels, and Financial Impact

Beyond the basic categorization of climate risks into physical and transition risks, it is important to understand the underlying risk drivers, how they are transmitted to the financial system, and the subsequent financial risks that can arise.

Climate Risk Drivers

Climate risk drivers are transitional and physical risks, as explained above, which can be broken further down into environmental climate risk drivers, such as extreme weather events, social ones like climate migration, and governance ones like regulatory non-compliance. These drivers lead to financial risks through different “transmission channels.”

Transmission Channels

The transmission channels are the pathways through which climate risk drivers can affect a company’s financials. They include:

  • Lower profitability: Increased oil and gas prices and risks to global supply changes from extreme weather events will raise the costs of everything, leading to lower profitability.
  • Real estate and asset value decline: Physical events can damage property, and transition risks can devalue at-risk assets, particularly those reliant on fossil fuels.
  • Household wealth and spending power: Climate risks can affect the broader economy, reducing consumer spending power and demand for goods.
  • Compliance and legal costs: Companies facing litigation for climate inaction or new regulations can lead to increased spending on compliance measures and legal costs.

Financial Risks

These transmission channels ultimately lead to various financial risks, which include:

  • Credit risk: Changes in companies’ financial health due to climate risks.
  • Market risk: Volatility in markets as a result of climate change, affecting asset prices and investment returns.
  • Operational risk: Disruptions to business operations from physical climate events or regulatory changes.
  • Liquidity and funding risk: Challenges in accessing capital due to climate risks.
  • Reputational risk: Damage to a company’s brand and customer loyalty due to perceived inadequacies in managing climate risks.

What Is a Climate Risk Assessment?

Climate risk assessment is the process of identifying and assessing climate-driven changes and considering how they might affect business.

In some cases where companies are anticipating facing a climate risk reporting regulation, like California’s SB 261, a climate risk readiness assessment may be more appropriate. With a climate risk readiness assessment, companies can better understand their readiness to comply with that regulation and what they need to do to get there.

Every company, regardless of its size, geography, or sector, will need to conduct a climate risk assessment. The table below shows a snapshot of some different market segments and why they will need a climate risk assessment:

Which Companies Need a Climate Risk Assessment

Company TypeMid-Market Public CompaniesPrivate or Public Mid-Market CompaniesSME Private Companies
Climate Risk RegulationsRequired to report climate disclosures to SEC Indirectly impacted by California’s SB 261, CSRD, & SEC Climate RulesNo regulations; aspires to lead their sector leader in climate strategy
Climate Risk Pain PointsNot yet prepared to formally report on the risks associated with non-compliance, financial penalties, and negative investor public perception Potential for future regulation impacts, operational disruptions due to climate events, supply chain vulnerabilities, and Scope 3 impactMissing opportunities in new markets, reputational risk if not perceived as a leader in sustainability
Climate Risk Assessment DriversSEC Climate Disclosures, EU’s CSRD, California’s SB 261, ISSB climate scenario analysis, and Pressure from investor and customersPressure from investors and customers that fall under climate risk disclosure regulationsCompetitive advantage, innovation, market differentiation, alignment with sustainability trends
Climate Risk Assessment NeedHighMediumLow

Why Climate Risk Matters to Your Business Now More Than Ever

Climate risks are not some faraway issues that companies need to consider in their long-term planning. They are a huge issue today. They will affect every company, big or small, in every country and sector.

Whether directly in the form of the physical risks that are accumulating as the global temperature rises year-on-year or from the reporting regulations that companies will have to comply with in the next couple of years. Or indirectly from disruptions in the supply chain, the depletion of certain resources, like water, or being impacted by regulation through a company they supply to. Climate risks represent a financial risk to all companies.

Here is how your company might be affected today:

Regulatory Impacts

The global regulatory landscape for climate risk reporting has advanced significantly in recent years. In the coming years, tens of thousands of companies will have to identify and report their material climate risks. To ensure compliance, companies will need to start preparing today for the following upcoming rules:

  • California’s SB 261: California’s TCFD-aligned climate risk reporting regulation (SB 261) will require up to 10,000 public and private companies that do business in California to begin reporting on their climate risks in 2026 and every year bi-annually after that. Companies should start this year by assessing their climate risk readiness to better understand how prepared they are to meet this reporting regulation. Ahead of beginning to collect data in 2025 for their 2026 report.
  • SEC Climate Risk Disclosure Regulation: In 2024, the SEC will release their climate risk disclosure rule for publicly traded US companies. The SEC rule will follow the same TCFD-aligned reporting needs as the California SB 261, which means understanding your climate risk readiness should also be a first step to ensure they are prepared to meet compliance.
  • Corporate Sustainability Reporting Directive (CSRD): The CSRD is the EU’s sustainability reporting regulation. It will require both EU and non-EU companies to report on their climate risks beginning in 2025. The CSRD will eventually have 50,000 EU and around 12,000 non-EU companies identify, assess, and report on their material climate risks. With the first reports for the upcoming CSRD in 2025, companies affected by the CSRD should start to identify and assess their climate risks to get ready for reporting today.

Even if they are not directly affected by these regulations, the inclusion of supply chain climate risk reporting will indirectly affect far more companies.

Financial Impact

The other main climate risks facing your business today and in the short term fall under physical climate risks, liability risks, and reputation risks:

  • The physical climate risks of climate change become more evident as each year passes. The World Economic Forum’s Global Risk Report for 2024 put extreme weather events as the second most significant risk that companies should consider in 2024, and more CEOs than ever consider exposure to climate risks as a sign of significant financial risk.
  • Liability risk is also an issue for companies today as climate-related litigation cases are climbing every year. In 2023, the SEC handed out the largest-ever fine for greenwashing. The $19 million DWS penalty was for misstating climate and other sustainability performance. Expect fines like this to become more common in the next 1-3 years as climate reporting regulations come into play.
  • With an increased threat of legal action against greenwashing and consumers being more eco-conscious, reputation risk is also something businesses should be mindful of today. To avoid losing customers and revenue you should ensure your climate reporting is accurate and transparent.

Assessing Climate Risks in Your Company

  • Climate Risk Readiness Assessment: The first step in managing climate risks is conducting a climate risk readiness assessment. This will enable you to understand if you are prepared to comply with upcoming regulations and what risks your company is exposed to.
  • Risk Mapping: Use tools like GIS systems, remote sensing equipment, or simple climate risk maps like this one from NYT. To assess the most important risks in your area and across your company’s value chain.
  • Scenario Analysis: Use the different emissions scenarios created by the IPCC or IEA to assess risks under different climate change and emissions reduction scenarios. Consider how different regulatory, market, and technology scenarios might impact your company.
  • Data Collection and Analysis: Collect climate data across your company’s operations (Scope 1 and 2) and value chain (Scope 3) to understand risk exposure and for effective, data-informed emissions reduction strategies.
  • Tools and Resources: Invest in software tools that can compile and analyze climate data. Also, use reporting guidance from the ISSB and TCFD to ensure you are assessing risks in line with the best and most current methodologies.

How to Mitigate Climate Risk in Your Company

Simple risk assessment process flow chart

Once you have assessed climate risks in your company, you should then build an effective strategy to mitigate or adapt to them:

  • Develop a Climate Risk Management System: Develop a system for managing risks. This could involve moving company infrastructure to somewhere with less risk exposure, diversifying suppliers, and investing in low-carbon technologies.
  • Engage with Stakeholders: The majority of Most companies’ climate risks will be tied up in their global supply chains; working with current suppliers to share data and work toward decarbonization targets or finding new suppliers could have an oversized effect on reducing climate risks and amplifying opportunities.
  • Reduce Emissions: Reducing emissions by implementing renewables or energy efficiency programs reduces companies’ exposure to transition risks, such as increased fossil fuel costs and carbon taxes, and opportunities like improving brand reputation.
  • Adapt: In situations where climate risks are unavoidable, companies must adapt proactively. This could include on-site water storage in water-stressed areas or moving away from areas susceptible to flooding.
  • Continuous Monitoring: The one thing about climate risks is they evolve over time; some may get worse over time, while others may not turn out as bad as anticipated; conducting regular climate risk assessments and iterating on management systems ensures climate risks are kept at bay.

Climate risks are not something in a far-off future; they represent major risks for companies today. With growing regulation, increased extreme weather events, and a whole host of other compounding climate-related risks, companies need to start identifying and mitigating their climate risks ASAP.

Not doing so exposes businesses to the reputation and legal risks of non-compliance, loss of supply of materials, damage to property, and loss of competitive advantage. Therefore, to avoid this, companies must start taking proactive steps today!

The best place to start is to ensure you are ready to report to climate risk reporting regulations and identify risks through a climate risk readiness assessment.

Reach out to begin yours, and start managing your climate risks like you manage your financial risks.

Disclaimer: Good.Lab does not provide tax, legal, or accounting advice through this website. Our goal is to provide timely, research-informed material prepared by subject-matter experts and is for informational purposes only. All external references are linked directly in the text to trusted third-party sources.

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