Disregard for physical climate risks is locking corporates into dangerous futures
By Swenja Surminski
There has been a seismic shift in corporate awareness and governance of climate risks over the last two years. More and more investors are demanding that businesses identify and mitigate their exposure to climate change, and regulators increasingly expect that firms quantify and disclose their climate-related risks. Under the reporting framework developed by the Task Force on Climate-related Financial Disclosures (TCFD) a growing number of companies are now assessing and reporting different types of climate risks and are applying environmental, social and governance (ESG) frameworks to their financial decisions. On the flip side, inaction on climate change or a lack of ambition is becoming a source of liability and legal disputes.
Are corporates fit for today and for the future?
As highlighted by the recently published Third UK Climate Change Risk Assessment (CCRA3), awareness of climate change within the corporate sector may be growing but concrete action to reduce the risks is still lagging, particularly with regard to the physical risks. And while many corporates are adopting ambitious emissions reduction targets, there are increasing concerns about greenwashing and couching business-as-usual in attractive sustainability terms. The recent report of the Transition Pathway Initiative highlights the significant imbalances between performance and action to achieve these targets. Many short-term business models are not geared up to deal with risks of this scale and in the words of the investment firm BlackRock (2019): “Markets show blissful ignorance.”
A recent survey of UK businesses that we carried out as part of the CCRA3 project shows that for most corporates – and particularly SMEs – addressing climate risks is still at an early stage. Of those respondents who were concerned about climate risks impacting their businesses, almost half stated that they had not assessed the risks. Even those who have assessed them struggle to quantify the impacts and cannot demonstrate how their actions are reducing the risks.
Feedback from our discussions with businesses as part of the CCRA3 project ranges from “this is the future stuff, not material enough today”, to “we have insurance”, or “we expect the state to manage risks”. In particular, there is little evidence that the growing awareness of climate risks (and their disclosure) has led to changes in investment decisions, as highlighted by the CCRA3. Corporates often also rely on others to take action, particularly in terms of infrastructure resilience in the face of climate change. Indeed, the CCRA3’s investigation of risks to business and industry highlights that there is a lack of understanding of the systemic nature of climate change, and of the wide range of indirect and cascading impacts. CCRA3 highlights that some sectors are already experiencing disruption of their supply chains and distribution networks, or loss of business due to employees and customers struggling with extreme weather events such as floods or heatwaves.
Avoiding compounding risk and lock-in effects
Of course, climate change impacts are spread unevenly across the corporate world as well as the physical globe. The degree to which business and industry are exposed to these risks depends on many factors, including location, type of activity, business model and size. Importantly, these impacts work through different channels and there are many interdependencies and thresholds that can lead to a significant rise in the scale and magnitude of risks. For example, changes in the natural environment lead to shrinking natural capital, with negative impacts particularly for agriculture and fisheries but also for wider business sectors that depend on clean water and other ecosystem services. Additionally, most business functions depend on reliable infrastructure, with disruptions a key risk for site operations, access to markets, supply chains and distribution networks. Similarly, employee productivity and staff wellbeing can be negatively impacted by heatwaves. And international interconnectivity means that impacts on one part of a business value chain can spread and cause significant indirect disruption and damage.
The CCRA3 has investigated current and future risk trends and asks whether adaptation action is already in place in the UK. Early findings indicate that none of the current and future risks to business from climate change identified in the second Climate Change Risk Assessment (CCRA2) have decreased in magnitude. This partly reflects an improved ability to assess and report these risks, but also the fact that business decisions continue to create additional risk of ‘lock-in’ effects: business decisions made today to invest in assets, design a product or locate a business site can determine physical climate risk levels both today and tomorrow, and may be irreversible or costly to change later. The CCRA 3 identifies lock-in as a key challenge and the threat underlines the importance of not misunderstanding climate change as a distant problem but making it an essential component of current and future planning and decision-making.
In England and Wales, a key example of lock-in is the choice of location for business sites. New research by the Grantham Research Institute for the Zurich Flood Resilience Alliance investigates where new businesses premises are being built in the context of current and future flood risk. Initial results indicate that between 2008 and 2018 a total of 7.82% of new business sites were built in high-risk flood zones (in this context this means areas with a 1% annual chance of flooding from river and surface water and/or a 0.5% annual chance of flooding from sea). As climate change is expected to increase flood risk levels significantly, this exposure is expected to increase – and even businesses currently outside the high-risk zones may find themselves at high risk as flood risk zones expand and shift geographically. This also underlines the importance of adaptation action and more investments in flood resilience.
Early lock-ins also mean that corporates will struggle to take advantage of opportunities in terms of shifting demand for products and services. CCRA3 finds that there is a growing market not only for green and low-carbon but also for climate resilience services and products – however, innovation and capitalisation remain slow.
Data and models: a stumbling block for business and industry
Lock-ins are also caused by lack of understanding of data and models. The last two decades have seen an explosion in available datasets and simulation models to inform them. However, concern has been growing over the reliability of climate and impact model data for quantitative risk assessments. Several commentators have called for a more nuanced interpretation of models and data: one mediated by expert opinion, process understanding and the role the data is designed to play in specific finance and business decisions (e.g. Stainforth and Calel, 2020; Swart, 2019). But to date there has been a lack of meaningful collaboration between those making financial decisions, those performing the latest scientific risk analysis and those packaging this into information tools and services.
While innovation is fast, the growing awareness of climate and environmental issues has led to a “climate intelligence arms race in financial markets” , with many black-box solutions obscuring limitations, purpose and value of risk analytics. One problem for many in the business and industry communities is that climate data can be too complicated, preventing them from using or integrating it into their own business models and tools. Importantly, new data and computational power can only help build adaptive capacity if deemed usable and relevant by businesses.
Our stakeholder engagement reveals that the lack of sector-specific scenarios and region-specific risk assessments pose an information gap for companies. For example, engagement with insurance brokers and catastrophe modellers reveals that there are significant gaps in knowledge and understanding about current and future risks, particularly when considering the interplay between hazards and vulnerabilities. The confidence in industry assessments of climate change impacts remains low despite the wealth of expertise in general risk analytics. Furthermore, companies that are attempting to assess climate impacts are confronted with a very wide range of tools and approaches, which makes comparability of results difficult and which can also lead to misinterpretations due to the complexity of the assessments.
Considering physical, transition and litigation risks together
A final driver for lock-in highlighted by CCRA3’s assessment of business and industry risks is the lack of a “joint assessment of physical, transition and litigation risks and their interdependencies across different climate scenarios”. The UK’s net-zero target will have important implications for all businesses and their domestic operations and footprint and will also influence future investment strategies through transition risks. But the interplay between physical climate risks and the shift towards a net-zero economy remains under-investigated.
It is clear that in the long term a successful shift to net zero will help limit physical impacts, but there could be trade-offs, at least in the short term, where responding to extreme events such as flooding and heatwaves could entail energy- and resource-intensive processes that may also affect the ability of companies to achieve their emission reduction targets.
Importantly, business decisions taken today will impact both the ability to transition to net-zero and the ability to cope with physical risks. Improved risk analytics will also increase the cost of capital, particularly when used for insurance pricing or investment decisions. This underpins the importance of transparency and quality control of data and its applications.
Climate change is a reality, not just a risk. Impacts are cascading through natural, social, economic and financial systems – directly and indirectly, causing damages and losses, increasing existing vulnerabilities and triggering reactions in behaviour, policy change and regulatory interventions, which in turn influence future risk levels.