Climate Risk and Sustainability
Climate change impacts are felt across the globe in various sectors. Let’s explore the implications and discover a road to sustainability.
Climate change is a significant geopolitical risk that can affect global stability. The impacts of climate change, such as resource scarcity, food insecurity and migration outflows and population displacement, can lead to heightened security risks including conflicts between countries. For example, water scarcity in the Middle East has led to tensions and conflicts between Turkey, Syria and Iraq because of the sharing of the Tigris and Euphrates rivers.
Extreme weather events, such as hurricanes, floods and wildfires, can also disrupt supply chains and impact infrastructure, leading to economic instability and affecting a country's military readiness. For example, the US military has recognized climate change as a national security threat and has taken steps to mitigate its impacts.
The Paris Agreement on climate change is an example of how geopolitics can facilitate global cooperation to address the issue. This treaty, signed in 2015, is a legally binding accord between 196 countries to limit global warming to well below 2 degrees C above preindustrial levels.
However, geopolitics can also hinder efforts to address climate change.
Below, we will discuss climate risk and sustainability to gain a better understanding of its relationship with geopolitical risk.
Defining climate risk and sustainability: Understanding its relationship with geopolitical risk
Climate change is one of the most impactful global challenges of our time. In the years ahead, the climate challenge is likely to be cross-cutting, including the environment, government, business, finance and health.
As the effects of climate change continue to intensify, understanding climate-related risks and developing strategies for mitigating those risks have become top priorities for businesses, governments and societies around the world.
Climate-related risks are defined as the potential negative impacts of climate change on businesses, governments and society. The potential impacts of climate change can take many forms, including physical risks — such as rising sea levels and damage to infrastructure and property from extreme weather events — and transition risks, such as those associated with the shift to a low-carbon economy.
Types of Climate Risk
There are several different types of climate risk, including physical, transition and liability risks, which we will discuss below:
- Physical climate risk: The direct impacts of climate change on physical assets, such as buildings, infrastructure and natural resources. The physical risks of climate change include rising sea levels, extreme weather events and the increased frequency of natural disasters.
- Climate transition risk: These are risks associated with the transition to a low-carbon economy, such as changes in energy prices, shifts in consumer behavior and the development of new technologies. Climate change transition risks can impact businesses and industries that are heavily reliant on fossil fuels, as well as those that have not yet fully adapted to the new low-carbon paradigm.
- Climate change liability risk: Businesses that fail to address climate change may face lawsuits and fines from issues such as failing to reduce greenhouse gas emissions or causing environmental damage. Liability risks can be particularly significant for businesses operating in industries with a high environmental footprint, such as energy, transportation and agriculture.
- Climate change reputational risk: The potential damage to a company's reputation and brand because of its association with climate change or environmental degradation. Reputational risks can impact a company's ability to attract investment, secure customers and retain employees.
- Climate change regulatory risk: The potential impact of new regulations, policies and taxes related to climate change on a company's operations and profitability. Regulatory risks can impact businesses across a range of sectors, from energy and manufacturing to finance and insurance.
The dangers of climate change: Understanding its risks and implications
How climate risk is affecting the oil and gas industry
The financial industry is placing greater emphasis on climate risk, in response to mounting pressure from investors and regulators, to factor in the effects of climate change when making investment decisions. This has led to the world's largest investors reevaluating how they assess energy companies and allocate funds across the sector. The oil and gas industry has raised concerns that the sector is facing tighter funding options, increased calls for climate disclosure and a rise in the cost of capital.
This presents a significant long-term strategic challenge for the industry. In certain regions, financial markets are moving more quickly than regulators, creating an impetus for action.
Climate risk and the energy transition are influencing various parts of the financial system in different ways. The largest asset management funds are facing significant social and regulatory pressure to address climate risk. This has prompted many asset managers to reduce their exposure to oil and gas.
Exchange-traded funds (ETFs) have increased their focus on sustainability factors. These ETFs have almost $50 billion in assets under management. If current growth rates continue, the assets in these funds could surpass $400 billion by 2025.
While demand for oil and gas is expected to remain high for at least another decade, there is growing pressure to transition away from these fuels. The financial markets are playing an increasingly important role in driving this transition due to the lack of coordinated policies across countries.
Framing the energy sector’s potential exposure
Some companies have already recognized the importance of addressing climate change through adaptation strategies. Oil and gas companies with global reach have been reporting their preparedness for climate change since the 1990s.
However, recent trends in atmospheric concentrations and temperature suggest the frequency and intensity of climate-related risks are increasing, thereby challenging established frameworks.
In some cases, the severity of climate-related events is surpassing previous standards of measurement. For example, rainfall patterns in parts of Texas are changing, and levels once considered rare enough to be classified as 100-year events have been reclassified as 25-year events.
The fact that the energy industry operates globally means that chronic risks associated with rising temperatures are a generalized risk for which companies must prepare.
From climate models to economic indicators: Quantifying climate risk with the right tools
Assessing and quantifying climate-related risks has become a crucial area of focus for energy producers and consumers following the 2017 recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) recommendations.
We expect TCFD implementation to shift toward a focus on physical climate change risks, which include risks associated with higher emissions and temperatures, and not just transition risks, such as regulatory-driven commodity demand destruction in a 2-degree C or lower climate scenario.
The intensity of physical risks will vary depending on the location of different assets and operations. However, assessing these risks beyond temperature and precipitation — such as changes in local sea level or acute events such as flooding, drought and wildfire — requires more modeling efforts.
To provide the more granular assessments that investors are seeking on the impact of climate change, an integrated approach that combines climate and economic modeling could be developed to assess and quantify the financial implications of physical climate risk.
Using climate models to assess physical risk
Global Climate Models
Global climate models (GCMs) are used to predict various climate variables, such as temperature, precipitation, sea-level rise and soil moisture. Due to the need to run the models and provide output on a global scale, the GCM provides results at a coarse resolution.
To achieve this, grid cells used by the models are several thousand square kilometers or more in size, sacrificing grid size for the ability to model all of the Earth's processes.
Consequently, GCMs may not take local features such as mountains into account and, in some cases, cannot model the effect of these features on variables such as precipitation because the mountains may fall within a single grid cell. While 47 of the 62 models used in the last International Panel on Climate Change (IPCC) assessment have publicly available results, their resolution remains coarse.
Of the 62 models used in the last International Panel on Climate Change (IPCC) assessment, 47 models have publicly available results.
Regional Climate Models
Regional climate models (RCMs) are useful for assessing the impact of climate change at a more local level. They can use the output of global climate models and apply various techniques to downscale their results, incorporating regional and local features that may affect weather conditions. This allows RCMs to provide much more detailed information for specific regions.
However, RCMs may not undergo the same stringent quality control tests that GCMs must pass to be included in the Coupled Model Intercomparison Project used by the IPCC. Furthermore, regional climate models are designed for specific regions and do not cover the entire globe, limiting their spatial coverage. As a result, RCMs that assess the impact of climate change across different IPCC scenarios may not be available for all regions.
Hybrid Models
The NASA Earth Exchange Global Daily Downscaled Projections (NEX-GDDP) dataset is a hybrid model that combines GCM and RCM techniques. It provides results for two scenarios, representative concentration pathways 4.5 and 8.5, as well as downscaled results from the GCMs on a global scale in grid cells that are 25-km wide and 25-km long.
This resolution is much higher than any GCM and is useful for physical risk assessments for TCFD disclosure. The NEX-GDDP dataset includes temperature and precipitation data across 21 GCMs, making it possible to conduct a multi-model analysis.
Climate risk management: Mitigating and protecting businesses and governments from climate impacts
The European Central Bank released a report on July 8, 2022, detailing the results of a climate stress-testing exercise performed on its member banks. The purpose of the exercise was to evaluate the ability of these institutions to withstand climate change financial risks, including exposure to physical assets and transition risk.
The report found that only 42% of the participating banks had integrated climate change into their balance sheet management practices. The results of this exercise will likely serve as a benchmark for other central banks around the world.
Central banks seek incorporation of climate risk factors in financial stress tests
The ECB assessed its member banks' ability to withstand climate change financial risks. It revealed that only 42% of participating banks have integrated climate change into their balance sheet management.
The ECB’s report also highlighted the need for additional transparency in reporting and assessing emissions, dependence on fossil fuel-heavy sectors for revenue and the use of inaccurate proxies in the bottom-up modeling of climate risks.
The ECB projected aggregate losses of €70 billion over three years for participating banks and warned that losses would likely be much higher in affected areas.
On the regulatory side, the EU has adopted measures to not just facilitate decarbonization, but also preempt so-called ‘carbon leakage’ through the introduction of the carbon border adjustment mechanism (CBAM), which aims to level the playing field between EU and foreign companies.
CBAM will have business implications for companies that import products covered by CBAM, namely steel and iron, aluminum, cement, fertilizers and electricity, as well as hydrogen and certain categories of indirect emissions.
CBAM will enter into force on October 1, 2023, but with importer obligations being restricted to reporting until 2026. From 2026 through 2034, CBAM will be gradually phased in, requiring affected companies to buy certificates that cover CO2 emissions linked to production.
The Network for Greening the Financial System is an organization that includes most of the world's largest central banks. Its purpose is to facilitate the sharing of information regarding the risks arising from climate change and how these risks affect financial stability. This could potentially lead to greater consistency and standardization across economies for managing climate risk.
Other central banks, including the People's Bank of China and the Bank of England, have also run climate stress tests on their banking systems. However, the rigorous nature of the ECB stress tests may inform not only other climate stress tests, but also the way climate risk is managed in the financial sector overall.
Mounting climate risks call for prioritizing capital to adaptation over simple mitigation
Previous UN conferences on climate change have focused on reducing greenhouse gas emissions to limit the damage from climate change. While the Paris Agreement and subsequent conferences aimed to implement this goal, many issues remain unresolved.
When global governments gathered in Egypt for the UN Climate Change Conference in November 2022, it became clear that the awareness of physical climate risk had increased. Extreme weather events are now commonly attributed to climate change, and financial companies, such as insurers, banks, asset managers and private equity firms, are all trying to account for and manage physical climate risk.
Reflecting the need for mitigation and the sustained focus on physical climate risk, the Conference of the Parties (COP) to the UN Framework Convention on Climate Change featured discussions on adaptation finance. Adaptation finance, a feature of COP for decades, is ordinarily used to absorb the impact of increased emissions that cannot be reduced quickly.
The availability of minor public or blended finance capital allocations to private companies in developing economies could reorient local business ecosystems around climate-responsive infrastructure and supply chains.
Attracting Adaptation Capital
Developing economies facing the need to finance infrastructure hardening and other adaptation projects are competing for resources with developed economies dealing with their own financing needs because of the increasing frequency and magnitude of weather and climate-related disasters.
The US National Oceanic and Atmospheric Administration reported that between January and July 2022, the US had nine weather and climate-related disasters, each with losses of more than $1 billion. Last year, there were 20 such events that cost a total of $152.6 billion.
Although industrialized countries are responsible for a large share of emissions that cause environmental damage, it is challenging to convince domestic political audiences to provide funds to developing economies to address the damage.
However, the public perception of adaptation has an advantage that mitigation never had. The share of the global population that has firsthand experience of the aftereffects of extreme weather events is no longer concentrated in the Global South. This has led to more people in more countries wanting better protection.
The drive for adaptation carries a sense of urgency that mitigation never could, in that the associated physical risk is visible and quantifiable.
At the 2021 UN Climate Change Conference, blended finance was discussed mostly in the context of mitigation. There was a significant amount of dry powder capital available in the global financial system for investment opportunities that ideally met both rate-of-return and climate-conscious criteria.
If a country, developed or developing, offers incentives that allow investors to expect a strong rate of return on adaptation-linked investment projects, particularly if the investments are backed by loan guarantees or other risk-reduction tools by multilateral financial institutions, these incentives could offer healthy inducements to investors looking for the right mix of climate consciousness and returns.
A Climate Risk-filled Future
In summary, climate change presents a significant challenge to the global community, and its impact is being felt with each passing year. The financial sector has a crucial role to play in helping to mitigate the risks of climate change, and it is heartening to see that many central banks and financial institutions are taking action to address this critical issue.
However, much work remains to be done, and it is vital that all major players from various industries continue to build on the progress achieved so far. By working together and adopting a comprehensive, collaborative approach, a more sustainable and resilient future can be realized for future generations.
