Climate risk refers to the potential negative impacts of climate change on economic and financial systems. It also includes the risks to physical assets and liabilities, as well as risks to the income and cash flows of companies and sectors. Climate risks are particularly important for banks. It can affect the value of the assets and loans that banks hold, as well as the ability of borrowers to repay their loans.
The “E” of ESG involves actively managing the impact of economic activity on the environment. Investors and analysts increasingly integrate ESG considerations into their analysis and decision-making to assess and manage climate risk. ESG scores provide valuable information on a company’s exposure to physical and transition risks related to climate change. But it’s important to note that they don’t directly indicate a company’s climate risk.
For example, aviation industry has high carbon footprint and so low ESG score. But currently, the low ESG score does not have negative impact on its financial perspective. It’s important to note that this does not mean that it is not exposed to climate risk. Climate risk can manifest in both physical and transition risks. The company’s exposure to these risks can change over time as the impacts of climate change become more severe. This could be as public policy and consumer preferences evolve. Additionally, there are also reputational risks and other non-financial risks associated with poor ESG performance.
On the contrary, it is possible for an industry with a high ESG score to still have a high level of climate risk. For example, a renewable energy company has a high ESG score because of its low carbon emissions. The company is still exposed to climate risk. These risk include changes in weather patterns that could impact its production capacity. Or delay in regulatory changes that could reduce the demand take-up for green energy.
A high ESG score is generally considered a positive indicator. However, it is not the only factor considered when assessing a company or industry’s climate risk.
Climate Risk Generic Models:
Climate risk can be broken down into buckets and modeled in a rather transparent manner. The following are a few examples of risk models:
Physical risk models: These models assess the potential impacts of climate change on physical assets and infrastructure, such as buildings, roads, and bridges. They can be used to estimate the potential costs of damage from extreme weather events, sea level rise, and other climate-related hazards.
Transition risk models: These models assess the potential impacts of climate change on the transition to a low-carbon economy, including the potential for stranded assets and the risks to companies and sectors that are heavily dependent on fossil fuels.
Liability risk models: These models assess the potential legal and regulatory risks associated with climate change, including the potential for lawsuits and regulatory penalties related to emissions and other climate-related impacts.
Integrated risk models: These models combine elements of physical, transition, and liability risk models to provide a comprehensive assessment of a company’s or sector’s exposure to climate risk.
Downscaling models: These models use GCM (General Circulation Models) and RCM (Regional Circulation Models) to downscale the global or regional data to a local level, providing a more detailed and site-specific assessment of the risks and impacts of climate change.
Some key matrices & data points
Key risk matrices and data points used in climate risk modeling can vary depending on the type of model and the focus of the analysis. However, some common data points and risk matrices used in climate risk modeling include:
Temperature and precipitation: Data on historical and projected temperature and precipitation patterns is used to assess the potential impacts of climate change on physical assets and infrastructure, such as buildings, roads, and bridges.
Sea level rise: Data on historical and projected sea level rise is used to estimate the potential costs of damage from coastal flooding and storm surge.
Extreme weather events: Data on historical and projected frequency and intensity of extreme weather events, such as hurricanes, floods, and droughts, is used to estimate the potential costs of damage and disruption to economic activity.
Carbon pricing: Data on historical and projected carbon prices is used to assess the potential risks to companies and sectors that are heavily dependent on fossil fuels.
Regulatory environment: Data on historical and projected climate-related regulations and policies is used to assess the potential legal and regulatory risks associated with climate change.
Data on economy and sectors: Data on historical and projected economic growth and activity in different sectors is used to estimate the potential impacts of climate change on the economy.
Data on physical characteristics of the site: Data on physical characteristics such as soil, topography and land use of the site are used to downscale the global or regional data to a local level, providing a more detailed and site-specific assessment of the risks and impacts of climate change.
Risk matrices are used to quantify the likelihood and potential impact of different climate risks, and can be used to identify which risks are most significant and which should be prioritized for further analysis and management.