We are living in an era where climate change impacts every aspect of our lives, and businesses are no exception. As climate impacts intensify, underestimating the adverse effects of climate change exposes companies to litigation risks, potential asset overvaluation, and sudden devaluation. This article explores the current level of understanding and initiatives by the C suite to deal with climate risk. The term is quite well established now, but we still have some distance to go before the implications are fully internalised and active actions are taken to mitigate it. This tendency primarily stems from the quarter-to-quarter result orientation of businesses. The secondary cause is the business instinct to prioritise near-term performance while not planning for long term resilience. After all, it is not easy to look beyond 5-10 years for an event with no precedence.

This article explores Climate Risk and how it is perceived at the executive level. It looks at the role of leadership in mitigating or adapting to climate risk.

Do Business Leaders Underestimate Climate Risk?

A Verdantix survey revealed that only 37% of leaders acknowledge physical climate risk as a significant threat to their operations, while a staggering 40% believe they face minimal to no threat.

This disconnect between perception and reality is alarming, especially considering the escalating frequency and severity of climate-related events across the planet. Most companies are failing to account for climate risks, of both types - ‘physical risks’ and ‘transition risks’.

This dual oversight can lead to a series of problems - from inaccurate financial projections, misaligned strategy, shareholder dissatisfaction, regulatory non-compliance to severe reputational damage. The ones that do take this into account are likely to create a more resilient business and outperform peers. For example, a study by McKinsey shows that resilient companies generated 10% more in Total Shareholder Return (TSR) than less resilient peers during the economic downturn between Q4 2019 and Q2 2020. In the subsequent economic recovery from Q2 2020 to Q3 2021, this differential grew to as much as 50% .

There are 2 major types of risks that can have an impact on the company’s financials, physical and transition risk.

In the ‘Physical Risk’ scenario, the following are some examples in the horizon of 5-10 years. This time period may not be seen as ‘near-term’ by companies. However, a logical approach would suggest that if companies can make 5-year financial plans, they must also integrate climate risks into these timelines.

a) The impact of Extreme Heat – It is clear to all of us that temperatures are rising. We are looking at anywhere between 1.5-2°C degrees average rise in temperature by 2030-35. This is just the average estimate- the peak change could be anywhere up to 4°C.

Studies clearly show that this change is going to cause lower productivity and higher illness among the workforce - both of which will drive up costs for every type of business.

The ILO (International Labour Organization) projects that by 2030, more than 2% of total working hours worldwide could be lost due to rising temperatures. For a typical construction company with 250 working days per year, this translates to 5 days of lost productivity annually.

Let us consider a typical construction company:

Financial Impact:

For a construction company with annual revenue of $100 million and a 15% profit margin ($15 million), the impact of extreme heat could reduce profits by $1.5 million per year.

This huge financial loss is only one element of the Physical risk!

b)The impact of Floods – It is estimated that annual damages from floods could be around 8% of asset value. This is a direct erosion in value of your balance sheet.

Imagine a bank that deals in mortgages – they will now need to change their pricing to account for this additional risk, or have additional loss provisions on their balance sheet to account for value erosion of the book.

This represents a significant financial risk that could affect the bank's capital adequacy ratios, lending capacity, and overall financial stability. Banks and other financial institutions need to assess their risk models to account for increased flood risk. They also need to adjust pricing of mortgages and other loans in high-risk area.

It is a foregone conclusion - Climate risk will start to show up on your financial statements. The time to act is now.

The second category is ‘Transition Risk’. While physical risks are evident, the financial implications of transition risks are equally important to address. As the world transitions towards a low-carbon economy, businesses face risks related to policy changes, technological shifts, market preferences, and political instabilities.

One of the most significant transition risks is the implementation of carbon pricing mechanisms, such as carbon taxes. For example, a study by CDP found that if a carbon price of $100 per metric ton were implemented, it could put up to $2.3 trillion of company value at risk globally.

Consider a hypothetical mid-sized oil and gas company producing 10 million barrels of oil equivalent per year. If a carbon tax of $50 per ton of CO2 were implemented, and assuming an emission factor of 0.43 metric tons of CO2 per barrel, this company could face an additional annual cost of $215 million. This represents a significant loss which could dramatically alter the company's valuation. Had the company proactively conducted climate risk assessments, it could have significantly reduced the financial impact of the carbon tax.

The Role of Business Leaders

Business leaders can play a crucial role in prioritizing climate risk assessments, including various carbon pricing scenarios, and ensuring that climate considerations are integrated into long-term strategic planning. At this level, they can drive innovation in low-carbon technologies and operational efficiencies, ultimately safeguarding their companies' futures against climate-related risks.

A push from regulators to start digging deeper into climate risk might also trigger a faster change. Right now – ‘climate risk’ is an analytical exercise – Once regulators start to force companies to price this in, things will change. For instance, imagine the Bank of England asks insurers to have additional reserves to account for climate exposure of the home insurance book? – this would then be a market-based mechanism to make the entire value chain act.

In conclusion, there is an urgent need for businesses to account for climate risks, make informed decisions and work towards creating long-term value in this highly dynamic climate landscape. The primary responsibility for this lies on the shoulders of leaders, especially those at the C-Suite level. With sharp foresight, if we integrate the risks of climate change into our business visions and processes, the catastrophic financial losses that loom ahead can be avoided. By embracing a more long-term vision of doing business, the physical risks of climate events, and the transition risks while we move towards a greener economy can both be deftly circumvented.