Climate-Related Risk

From Open Risk Manual

Definition

Climate-Related Risk refers to the potential negative impacts of climate change on an organization. In Risk Management context climate-related risks form a collection of fundamental risk factors or underlying causes which are expressed (realised) as more specific risks

Climate-related risks exist in any case and must be managed irrespectively of the causes of climate change. In connection with human induced climate change they form (over the longer term) a more complex system

Climate-Related Risk Taxonomy

The TCDF Report[1] divided climate-related risks into two major categories:

  • risks related to the transition to a lower-carbon economy and
  • risks related to the physical impacts of climate change.

Physical Risk

Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations’ financial performance may also be affected by changes in

  • water availability, sourcing, and quality;
  • food security; and
  • extreme temperature changes affecting organizations’ premises, operations, supply chain, transport needs, and employee safety.


Physical risks emanating from climate change can be event-driven (acute) such as increased severity of extreme weather events (e.g., cyclones, droughts, floods, and fires). They can also relate to longer-term shifts (chronic) in precipitation and temperature and increased variability in weather patterns (e.g., sea level rise).

Acute Physical Risks

Acute physical risks refer to those that are event-driven, including increased severity of extreme weather events, such as

  • cyclones, hurricanes, or floods
  • droughts
  • fires

Chronic Physical Risk

Chronic physical risks refer to longer-term shifts in climate patterns (e.g., sustained higher temperatures) that may cause sea level rise or chronic heat waves.

Transition Risk

Transitioning to a lower-carbon economy may entail extensive policy, legal, technology, and market changes to address mitigation and adaptation requirements related to climate change. Depending on the nature, speed, and focus of these changes, transition risks may pose varying levels of financial and reputational risk to organizations

Transition Risks can be segment as follows:

  • policy and legal actions
  • technology changes
  • market responses, and
  • reputational considerations.

Policy and Legal Actions

The Political Risk associated with and financial impact of climate-related policy changes depends on the nature and timing of the policy change.

Legal Risk (in climate-related risk context) is climate-related litigation claims being brought before the courts by property owners, municipalities, states, insurers, shareholders, and public interest organizations. Reasons for such litigation include the failure of organizations to mitigate impacts of climate change, failure to adapt to climate change, and the insufficiency of disclosure around material financial risks

Technology Changes

To the extent that new technology displaces old systems and disrupts some parts of the existing economic system, winners and losers will emerge from this “creative destruction” process. The timing of technology development and deployment is a key uncertainty in assessing technology risk.

Market Responses

Shifts in supply and demand for certain commodities, products, and services as climate-related risks and opportunities are increasingly taken into account.

Reputational Considerations

Climate change has been identified as a potential source of reputational risk tied to changing customer or community perceptions of an organization’s contribution to or detraction from the transition to a lower-carbon economy.

Mapping to the Open Risk Taxonomy

The impact of climate-related risks on an organization depends on the nature of the organization and its existing exposure to major risk types. In the context of the Open Risk Taxonomy climate-related risks are not a new form of risk but a new risk factor. A key design element of the taxonomy is the segmenttion into Category:Contractual_Risks, that is, risks that are associated with explicit legal contracts in which the organization participates and Category:Business_Risk, namely risks that threaten a firm's business plan and/or objectives without being linked to any concrete contractual relatioship.

The following tables indicate the (approximate) mapping of climate-related risks to existing risk types. The mapping is decomposed into several tables to capture the relevant sub-categories.

Mapping of Acute Physical Risks to Contractual Risks

Risks associated by existing contracts (credit risk, market risk etc.) can be exacerbated by acute physical risks. New contracts / markets that explicitly take climate-related risks into account may exhibit different behavior than the mapping suggest below.

Risk Type Mapping
Category:Credit Risk Idiosyncratic impact on the creditworthiness of clients exposed acute events (e.g with operations in affected areas). Potentially affecting large sectoral / regional portfolios
Category:Market Risk Sudden spikes in commodity prices, impact on stock markets affecting the value of existing holdings. Climate-related risk markets may behave in counter-intuitive manner
Category:Insurance Likelihood or severity of underwriten risk in excess of priced / capitalized models
Category:Pension Risk Incidental impact on asset/liability balance (via pension fund asset portfolio)
Category:Optionality Risk Adverse behavioral changes of clients exposed to acute events (increased drawdowns, altered pre-payment patterns)
Category:Human_Resources_Risk Key persons affected by acute events

Mapping of Acute Physical Risks to Business Risks

Acute Physical Risks map potentially to the entire spectrum of Business Risks

Risk Type Mapping
Category:Operational Risk Two subcategories of Operational Risk (Physical Damage, Business Execution) are direct maps of acute risk events
Category:Franchise Risk Acute events may reveal vulnerabilities and affect the reputation of the firm for risk management or even the viability of its business models
Category:Revenue Risk Acute events may disrupt existing budgets and revenue streams
Category:Funding Risk Incidental to the realization of other risk factors (credit risk, operational risk etc.) the firm may experience difficulties obtaining funding to support operations
Category:Human_Resources_Risk Incidental to reputational loss, the firm may experience difficulty fullfiling required positions

Mapping of Chronic Physical Risks to Contractual Risks

Chronic Risks can impact existing contracts when those are long-dated and/or where it is structurally difficult to mitigate risk on the face of increasing climate-related exposure

Risk Type Mapping
Category:Credit Risk Impact on the creditworthiness of (long-dated exposures) to client segments that are exposed to structural deterioration due to geography or business model that is affect by climate risk
Category:Market Risk Incidental to long-dated / exotic contracts
Category:Insurance Likelihood or severity of underwriten risk in excess of priced / capitalized models
Category:Pension Risk Incidental impact on asset/liability balance (via pension fund asset portfolio)
Category:Optionality Risk
Category:Human_Resources_Risk

Mapping of Chronic Physical Risks to Business Risks

Chronic Physical Risks map also potentially to the entire spectrum of Business Risks, in particular where management action is less able to reduce the exposure

Risk Type Mapping
Category:Operational Risk To the extend that the firm is unable to mitigate its exposure to physical damage or disruption of operations
Category:Franchise Risk Chronic exposure may question the viability of the firm's business models
Category:Revenue Risk Revenue streams may become more fragile / volatile
Category:Funding Risk Long term funding may be not available at normal prices
Category:Human_Resources_Risk Incidental to reputational loss, the firm may experience difficulty fullfiling required positions

Mapping of Transition Risks to Contractual Risks

Transition Risks can impact existing contracts when those are long-dated and/or where it is structurally difficult to mitigate the risk created by the transition process

Risk Type Mapping
Category:Credit Risk Impact on the creditworthiness of (long-dated exposures) to client segments that are exposed to structural deterioration due to a business model that is becoming obsolete (Stranded Assets)
Category:Market Risk
Category:Insurance
Category:Pension Risk Impact on asset/liability balances (via pension fund asset portfolio)
Category:Optionality Risk
Category:Human_Resources_Risk

Mapping of Transition Risks to Business Risks

Transition Risks map also potentially to the entire spectrum of Business Risks, in particular where the business strategy is not aligned with the nature and pace of the transition process

Risk Type Mapping
Category:Operational Risk Legal Risk from litigation associated with entities affected by the transition process
Category:Franchise Risk The firm's business model may be incompatible with certain transition scenarios. Increased sensitivity to the nature of policy choices implemented (Political Risk)
Category:Revenue Risk Revenue streams may become more fragile / volatile or be eliminated under transition scenarios.
Category:Funding Risk Long term funding may be not available at any price
Category:Human_Resources_Risk The broader pool of talent may be diminishing under transition scenarios as people opt for future-proof sectors

References

  1. TCFD Report, Recommendations of the Task Force on Climate-related Financial Disclosures, 2017

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