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Climate Risk: What are Physical & Transition Risks?

Article Overview

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.

Physical risks are the tangible effects that climate has on organizations– i.e. flooding, extreme weather events, etc. Transition risks, however, are more intangible. They concern the risks that accompany our global decarbonization transition.  

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.

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 proposals (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.

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”.

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