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Assess climate risk for your business in 6 steps

Christopher McClure, Animesh Shah
1/18/2023
Assess climate risk for your business in 6 steps

The final SEC climate rule is coming, and it's important to assess climate risk for your business. Our six-step approach can help.

Climate-related financial risks, generally referred to as climate risks, are the financial risks linked to climate change. Climate risk can affect financial balance sheets and lead to losses through standard channels, such as diminished asset valuations or increased loan defaults.

Assessing climate risk can help organizations identify the potential impact of adverse climate changes on business operations and their ability to sustain themselves in the event of future climate hazards. In anticipation of the upcoming final Securities and Exchange Commission (SEC) climate disclosure rule,1 now is a great time for organizations to use their current risk frameworks to begin assessing the potential impact of climate change.

Even when relying on existing risk frameworks, addressing the far-reaching and complex issue of climate risk can be overwhelming. Organizations that might be unsure of where to start can use a six-step approach to help identify, analyze, and evaluate such climate risk and ultimately inform risk management decisions.

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Defining climate risk categories: Physical and transition risk

Establishing definitions is critical to any in-depth venture, and understanding the different types of climate risk is essential. Climate risk comprises two types of risk: physical and transition.2

Physical risk. Physical risks arise from the physical climate (and weather) effects of a changing climate. Physical risks are classified as:

  • Chronic, or longer-term shifts in climate patterns, such as sea level rise, average temperature increases over decades, glacier melting, and glacier recession
  • Acute, or event-driven shifts such as cyclones, hurricanes, floods, and wildfires

Transition risk. Transition risks arise from the economic transformation and dislocation needed to drastically reduce, and eventually eliminate, net greenhouse gas (GHG) emissions and reach net-zero. Many countries have set this goal for themselves to reach by 2050. Transition risks are classified in four broad categories:

  • Policy and legal risks. These risks arise from changes in government policies, regulations, and mandates on existing products and services and from reporting obligations, such as carbon pricing.
  • Technology risks. These risks emerge when existing technologies become unsustainable or obsolete or when there is a demand for lower-emission products to replace existing ones.
  • Market risks. These risks occur when there is a significant shift in consumer preference, such as electric vehicles or solar panels over fossil fuel-driven energy.
  • Reputation risks. These risks stem from stigmatization of a sector (such as fossil fuel) and from customer perceptions that the organization is not doing enough to lower its carbon emissions and address associated negative impacts.

These four categories of risks transform into financial risks that include credit, market, operational, underwriting, and liquidity risks. This movement occurs through various macro- and microeconomic channels, including property damage, business disruption, capital depreciation, loss of income, and productivity degradation.

How to assess climate risk

1. Educate the organization and management

To start, organizations need to gain a better understanding of what a changing climate means for the economy. Doing so can help them develop a better understanding of the science, the implications, the trends, and even the technical language that can enable the business and its management team make better informed decisions.

Climate risk education can help secure buy-in from senior management – a much needed first step to the success of climate risk management.

2. Conduct a materiality assessment 

Organizations should explore and evaluate how climate change affects their business stakeholders, including customers, suppliers, industry, geographies, employees, and value chain. To assess, map, and rank climate risks specific to the business, organizations should conduct a materiality assessment. A materiality assessment is the process by which organizations identify and analyze possible risk factors that could affect the long-term sustainability of the business and its stakeholders.

In this materiality assessment, key stakeholders such as the board of directors, employees, customers, suppliers, and regulators can be surveyed to better understand what they see as material risks to the business and what issues they view as important. In addition to direct feedback from stakeholders, other existing resources, such as internal documentation and industry research papers, might help to create a complete picture of the company’s exposures.

A materiality assessment offers a complete view of where the business’s strengths, weaknesses, and challenges lie. It is a powerful tool in developing an effective climate risk strategy, and it is a valuable exercise for identifying the full extent of an organization’s climate risk profile.

3. Gather historical and current data

To understand climate risk and its impact, organizations need access to historical data that demonstrates the effect of climate and weather on their business. They also need to analyze current local and global data as well as predictions and models of how the climate will change in the future.

Some data elements necessary for assessing physical risks include:

  • Locations of offices, warehouses, manufacturing facilities, and supply chain participants
  • Historical and projected physical hazard data for these locations
  • Business resiliency data, including a disaster recovery plan, alternate power arrangements, remote work capabilities, supplier bottlenecks, and alternate suppliers
  • Community resiliency data that describes the readiness of the infrastructure to withstand climate hazards, including the airports, road connectivity, nearby hospitals, gas, electricity, supplies, and food services

Gathering this data helps organizations understand the weakest link in their value chain and to determine if materials or resources sourced from a single supplier (such as buildings, power, gas, or human capital) could be in jeopardy.

On the transition risk side, organizations should gather data and information about:

  • Change in government policy or industry regulations
  • Supply chain impact
  • Rising insurance policies
  • Financial and political risk
  • Reputational risk
  • Increased competition for resources
  • Impact on marketing

Understanding transition risk information can help organizations determine the risk of policy changes to their business, identify possible future stranded assets, take steps to avoid negative impacts, and capitalize on the opportunities presented by a changing landscape.

4. Plan for the assessment

Based on what they learn from evaluations and data, organizations should develop a road map to perform a climate risk assessment. The road map should establish the who, what, when, and how of the assessment.

Who. Identify subject-matter experts (SMEs) in each area and the responsible parties from each of the business units and geographies.

What. Determine the scope of assessment, including geographies to be considered, assets to be included in the assessment, and standards or guidelines that need to be followed.

When. Set a timeline for an assessment, dictated by factors such as:

  • Regulatory compliance needs (as driven by SEC or other agencies)
  • Expectations from investors, customers, the board, and suppliers
  • Company resources

How. Identify the following:

  • How the assessment will be performed
  • What scenarios (existing or potential) will be considered
  • Time period for the assessment (one year, multiple years, or decades)
  • Tools needed to assist with the assessment

Various agencies, including the Intergovernmental Panel on Climate Change (IPCC), the International Energy Agency (IEA), and the Network for Greening the Financial System (NGFS) have developed scenarios that businesses can use to assess their climate risk or develop business-specific scenarios. Scenario analysis plays a key role in helping organizations better understand how climate factors could drive changes in the economy and financial system. Such analysis is not meant to be a forecast, but rather a process of examining and evaluating plausible future pathways under certain conditions and assumptions.

The following scenarios are hypothetical and represent a range of possible “what if” future states of the world. They are intended to help show how climate factors could drive changes in the economy and financial system, along different possible future paths. Scenarios related to transitioning to a low-carbon economy explore different pathways for reducing emissions and implications for the economy and financial system.

Climate scenarios
IPCC3 2°C (RCP 2.6) The representative concentration pathway (RCP) 2.6 is consistent with an ambitious reduction of GHG emissions, which assumed GHG emissions would peak around 2020. Deemed a turning point, the GHG emissions would then decline on a linear path that aims to limit global warming to below 2°C above pre-industrial temperatures by 2100.
2.4°C (RCP 4.5) RCP 4.5 is an intermediate-emissions scenario, consistent with a future with relatively ambitious emissions reductions and GHG emissions, increasing slightly before starting to decline around 2040. It is aligned broadly with the GHG emissions profile that would result from the implementation of the 2015 nationally determined contributions up to 2030 followed rapidly by a 50% reduction of global emissions by 2080. It is considered likely to produce a warming of about 2.4°C.
2.8°C (RCP 6) RCP 6 is a high-to-intermediate-emissions scenario, where GHG emissions peak at around 2060 and then decline through the rest of the century. It is considered likely to produce a warming of about 2.8°C.
>4°C (RCP 8.5) RCP 8.5 is aligned broadly with current policies. It is a high-emissions scenario, consistent with a future with no policy changes to reduce emissions and characterized by increasing GHG emissions that lead to high atmospheric GHG concentrations. It is considered likely to produce a warming of 4.3°C.
IEA4 Stated Policies Scenario (STEPS) The scenario takes into account the policies and implementing measures affecting energy markets that had been adopted as of the end of September 2022, together with relevant policy proposals, even though the specific measures needed to put them into effect have yet to be fully developed.
Sustainable development scenario Innovation is central to the sustainable development scenario. The scenario is used to assess the contribution needed from clean energy technology innovation for a clean energy transition to net-zero carbon dioxide emissions by 2070.
NGFS5 Orderly scenario These scenarios assume climate policies are introduced early and become gradually more stringent, with both physical and transition risks relatively subdued.
Disorderly transition scenario These scenarios explore higher transition risk due to delayed policies or policies that diverge across countries and sectors. For example, carbon prices would have to increase abruptly after a period of delay.
Hot house world scenario These scenarios assume that climate policies are implemented in some jurisdictions, but globally the efforts are insufficient to halt significant global warming. The scenarios result in severe physical risk, including irreversible impacts such as sea level rise.

5. Execute the assessment

Climate-related financial risks are the sum of physical and transition risks, so in executing the assessment, organizations should address these categories individually.

Physical risk assessment

Organizations should examine their physical assets, suppliers, and customers and assess the effect of a weather-related disaster at their locations, which can help address questions such as:

  • What risks does our organization need to prepare for?
  • Which of our current and potential investment locations are at greatest risk from weather events?
  • What mitigation strategies can we apply to reduce these risks, and which will be most effective?
  • How can we incorporate long-term changes in climate conditions into our investment strategy?

Transition risk assessment

Organizations should examine the impact on their business of carbon price (internally determined or government mandated) as well as the impact of other noncarbon price-related government policies and regulations. Some examples of the country- and industry-specific noncarbon price policies include:

  • Corporate average fuel policy
  • Economy standards for passenger and commercial vehicles
  • Regulations on methane emissions
  • Phase-out of traditional coal-fired generation of electricity

In addition, organizations should determine the impact of:

  • Market uncertainties and low-emission technology advancements on the valuation of certain assets, such as fossil fuel reserves, gas-powered vehicles, and agricultural land
  • Demand for lower-emission products on the business’s operations and revenue, including any capital investments needed in technology development or research and development expenditure in new or alternative technology
  • Changing consumer behavior or increased raw material cost as reflected in reduced demand for certain goods and services, shifts in energy and production costs, or change in revenue mix

This analysis allows businesses to fully assess the potential financial impacts of climate-related transition risks and opportunities.

6. Report, mitigate, and re-assess

After taking the first five steps, organizations should report the assessment findings to internal and external stakeholders. They should also develop mitigation and adaptation plans for identified risks and repeat the process to assess and mitigate any residual or newly emergent risk.

The report should include, in addition to the assessment, the mitigation and adaptation strategy for physical and transition risks:

Physical risks. How does the company plan to mitigate or adapt to any identified physical risks, including but not limited to those concerning energy, land, water use, and management?

Transition risks. How does the company plan to mitigate or adapt to any identified transition risks, including:

  • Laws, regulations, or policies that restrict GHG emissions or products with high GHG footprints, including emissions caps
  • Laws, regulations, or policies that require the protection of high-conservation value land or natural assets
  • The imposition of a carbon price
  • Changing demands or preferences of consumers, investors, employees, and business counterparties

At a high level, investors want to understand how organizations might respond to nonfinancial changes in their environment. These changes include climate-related issues and other broad categories, such as shifting demographics, workforce and labor trends, and rising housing costs. In essence, investors need to know that the companies they invest in are paying attention to these issues and have a plan in place to respond to the risks and opportunities therein.

Businesses that assess climate risk now can be better prepared for upcoming regulations and for future climate hazards. This six-step, structured approach provides organizations with a framework to evaluate current threats, anticipate future threats, and make adjustments along the way.

1 “SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors,” U.S. Securities and Exchange Commission, March 21, 2022, https://www.sec.gov/news/press-release/2022-46

2 “Task Force on Climate-related Financial Disclosures: 2022 Status Report,” Task Force on Climate-related Financial Disclosures, October 2022, https://www.fsb-tcfd.org/

3 “Long-Term Climate Change: Projections, Commitments and Irreversibility,” Chapter 12 of “Climate Change 2013: The Physical Science Basis,” Contribution of Working Group 1 to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, 2013, https://www.ipcc.ch/report/ar5/wg1/

4 “Net Zero by 2050: A Roadmap for the Global Energy Sector,” International Energy Agency, October 2021 (fourth revision), https://www.iea.org/reports/net-zero-by-2050

5 “NGFS Climate Scenarios for Central Banks and Supervisors,” Network for Greening the Financial System, September 2022, https://www.ngfs.net/en/ngfs-climate-scenarios-central-banks-and-supervisors-september-2022

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