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. Unprecedented weather events such as Cyclone Freddy which ravaged Africa, devastating wildfires in Canada that blanketed eastern North America in thick smoke are some examples of climate change. The year 2023 has been marked as the hottest year ever recorded with July 2023 breaking records as the hottest month ever recorded.
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
Climate change is expected to have wide-ranging impacts on worldwide water availability, leading to the need for countries to adapt their resource management strategies. This will pose significant physical climate risks and economic consequences for governments and businesses, including limitations on electricity generation, agricultural losses, and disruptions in supply chains.
According to climate scenario forecasts by S&P Global Sustainable1, water stress and drought frequency will intensify in numerous regions in the coming decades. As a result, water will assume a greater strategic importance, sparking environmental activism and presenting new obstacles for companies and nations.
Climate risks to the supply chains
The impact of climate change is putting pressure on logistics networks from both ends. On one hand, regulatory measures targeting emissions from shipping are likely to result in longer supply chains, increasing costs for the entire system. On the other hand, unpredictable weather patterns are disrupting port operations and affecting shipping routes, as well as inland transport.
The low water levels in the Panama Canal through mid-2023 and the upcoming implementation of Europe's emission trading system (ETS) coming into force on Jan.1, 2024, highlights the urgency to address water scarcity issues as soon as possible.
While there are still infrastructure gaps at ports, particularly in developing economies, process inefficiencies are the main cause of delays in the industry. Therefore, it is crucial to prioritize digitization efforts in ports to improve operational efficiency and meet emission reduction targets.
Climate risk and food insecurity
The year 2024 is expected to bring about climate-related disruptions, with the influence of phenomena like El Niño. This could have a significant impact on agricultural production and pose challenges for policymakers in maintaining food prices.
El Niño is projected to contribute to food insecurity with global climate changes, including higher temperatures, abnormal weather patterns, and warmer oceans. These factors increase the chances of more severe floods and droughts.
Additionally, Russia’s withdrawal from the Black Sea Grain Initiative due to the conflict with Ukraine highlights the vulnerability of food supply chains to geopolitical events. To prevent domestic civil unrest, food insecurity and inflation, countries like India, Myanmar, and Indonesia imposed restrictions on the export of rice and palm oil in 2023.
If climate-related disruptions intensify in 2024 and negatively affect agricultural production, similar measures, such as export restrictions, subsidies, and price controls, may be implemented.
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 contributed 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).
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.
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.
In the recent COP28, held in Dubai, United Arab Emirates from Nov. 30 to Dec. 13, 2023, world leaders committed to triple renewable capacity and double energy efficiency by 2030 based on a historic text that was part of the first-ever Global Stocktake (GST).
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 2023 United Nations Climate Change Conference (COP28), creative finance was discussed mostly in the context of encouraging private investment in climate solutions and help drive energy transition in developing countries. There was progress seen at COP28 with the activation of the Loss and Damage fund. This was a funding mechanism designed to help developing countries facing climate change events like droughts and floods to cope with climate impacts.
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.