Climate Risk in Context

Resilience Insights Series: Part 2

Every day, more companies are seeking to measure and manage their climate risk. Investors are familiar with the key concepts of risk and have tools and approaches to factor the riskiness of investment decisions into their value propositions and deals. However, climate change raises many new dimensions for the industry that need to be understood in context. 

The Task Force on Climate-related Financial Disclosures (TCFD) focuses on two broad categories of climate risk and opportunity: transition risks that result from the move to a lower-carbon economy, and physical risks that result from the physical impacts of climate change.  Simply by raising the topic of climate risk management, investors can begin advancing action, but what that action will look like is still emerging. There is no standardized set of indicators that can serve as a proxy or single line that can be incorporated into financial models to determine performance. Climate risk is driven by many complex factors, from global GHG emissions to local weather patterns and from macroeconomic forces to facility operations. Climate risk is not just one thing — it is a function of many complex systems interacting in a world that is increasingly dynamic and uncertain. 

Climate impacts are not happening in a vacuum. Urbanization, disruption of natural systems, rapidly changing technology, and of course pandemics are all intertwining to undermine predictability and make planning based on historical conditions problematic. The past, and even the present, are not reliable indicators of the future.  

While there are different ways of defining risk, the diagram below is typical. Risk can be conceptualized as a combination of three parts:

A common approach to evaluating physical climate risk includes a portfolio-wide assessment of climate-driven hazards across asset locations. This type of analysis provides a strong starting place so that companies can look across their portfolios to identify potential hot spots. While it provides an important first step, it only looks at a part of the picture—the outside forces at a particular location that might impact an asset, i.e. the hazard. This approach can be highly sensitive to the variables that are considered and the specific climate scenarios used for analysis. This is why some companies that have commissioned similar services from multiple providers of physical risk analysis have found highly variable results. 

Beyond looking at the likelihood of climate driven hazards over time, companies must also consider exposure (i.e. what assets or other parts of the organization’s value chain might be impacted by each hazard type) and vulnerability (i.e. how sensitive those assets and value chains are). These three dimensions – hazard, exposure and vulnerability – together make up physical climate risk. There are many ways to evaluate these dimensions, from high-level desktop studies to detailed engineering exercises, and these different types of analysis can be deployed to answer a range of different questions. For example, desktop assessments might help organizations identify concentrations of risk by geography or asset type, while more detailed investigations may be used for asset acquisition due diligence or to direct investment decisions in asset protection.  The physical, operational and organizational measures that have been implemented to mitigate or manage those hazards and consequences in turn reduce vulnerability and ideally build adaptive capacity. Risk is also influenced by the way each asset helps to contribute to delivery of overall business goals. 

Similar risk frameworks might also be used to understand transition risk, a large category of challenges and opportunities related to changing policies, finance, reputation and other factors that might be presented by climate change, and companies are defining and evaluating these dimensions in different ways. While we won’t delve into transition risk here, it is important to remember that these analyses do not predict the future—no one can do that. They simply parameterize a wide range of variables to help us see patterns, evaluate probabilities, and make better decisions in the face of uncertainty. In fact, scenario analysis as a field of study was born out of the need to understand strategic ramifications for situations with either too many possibilities (making probabilistic modeling too expensive) or with too much uncertainty about the probabilities of its underlying factors (making probabilistic modeling insufficient).

While organizations that have reached a more mature understanding of climate-related risk are not necessarily all following the same approach, they are more proactive in their efforts to understand that risk and build up the necessary tools and processes to mitigate them. They are developing more complete toolboxes to evaluate risk at the right scale and level of granularity in order to support comprehensive risk management processes. They proactively gather and analyze data through established methodologies to inform overarching priorities, acquire and manage assets, invest in mitigation measures and structure deals. In other words, climate risk becomes incorporated into standard procedures across a range of scales and decision types. As this maturity develops, top-down hazard assessments can be matched with bottom-up asset level analysis to provide a clearer picture of what can go wrong, what has to go right, what should be done, and how this integrates into a comprehensive approach to risk management. 

GRESB Resilience Module respondents varied widely in their approaches to measuring and responding to climate-related risk. Nevertheless, 2020 Module data suggests that more organizations are beginning the process of understanding their climate-related risk, particularly physical climate risks. Some are even using scenario analyses based on climate projections to inform the analysis, as recommended by TCFD. However, many are still on their journey to understand how to translate concepts like “hazard,” “risk” and “vulnerability” into decision-useful outputs, suggesting that at this stage enthusiasm might be outpacing capability.

The significant growth in participation in the Resilience Module over the past three years speaks to the growing demand for new approaches to understand and manage climate risk. It is a promising step forward. However, there is still a lack of alignment around how the boundaries of risk are being defined and how risk is being measured. High-level, portfolio-wide assessments, the most common type of physical climate risk assessment reported in GRESB, is a great start. However, it does not replace the need for finer grained analysis that can be used to evaluate exposure and vulnerability at the asset level. To become resilient, asset operators are going to need to actively work to mitigate risks on site, and that will require investment which may be in competition with other priorities at the fund level. 

As GRESB moves to align with TCFD, and as more ESG programs, financial organizations and even nations do the same, there will hopefully be an increase in alignment around awareness and key concepts. The industry is still nascent, and there is a critical need for deeper-dive hazard and vulnerability assessments, including physical and transition risks, and expanded ability for organizations to manage uncertainty and create adaptive capacity.