18 September 2022

What is climate risk, and what does it mean for your organization


By Cervest

What is climate risk, and what does it mean for your organization

As billions of people face extreme heat warnings, droughts, wildfires and catastrophic flooding, our vulnerability to climate change has never been clearer. We must urgently start identifying the physical climate risk most likely to impact our assets, so that we can adapt to the inevitable climate volatility yet to come. But what exactly is climate risk, why does it matter, and what can be done about it?

In this article, we’ll explain:

  • What physical climate-related risk is, and how the risk levels to your assets are changing

  • What kinds of climate risk organizations are facing now and in the future

  • The various climate hazards that contribute to physical climate risk

  • What transition risk is, and what it means for your organization

  • How to map your physical climate risk and how it will evolve

  • How climate intelligence can help you map, monitor, and mitigate the climate risk to your assets

What is climate risk?

Climate risk is the potential for climate change to create adverse consequences for human or ecological systems. This includes impacts on lives, livelihoods, health and wellbeing, economic, social and cultural assets and investments, infrastructure, services provision, ecosystems and species.

For organizations, it can be defined in practical terms as the measure of vulnerability to climate-related impacts that have financial consequences, or that may affect various aspects of financial performance. Those consequences could be anything from minor inconvenience to a complete loss of an asset’s value or operability. With such high stakes, reducing the uncertainty of that outcome is business-critical.

Every organization in every sector, in every part of the world, faces varying degrees of climate risk – and that risk is escalating as climate change accelerates. In 2021 alone, extreme weather events caused USD329 billion in economic losses – 45% higher than the 21st-century average, says a report by Aon. These catastrophes are “increasing in frequency and severity,” it notes. In the coming decades, the impacts will be felt globally: a report from McKinsey warns that of the 105 countries it assessed, which represents 90% of the world’s population and 90% of global GDP, all “are expected to experience an increase in at least one major type of impact on their stock of human, physical, and natural capital by 2030. Intensifying climate hazards could put millions of lives at risk, as well as trillions of dollars of economic activity and physical capital, and the world’s stock of natural capital.” The severity of these outcomes will be determined by the ability of individuals, organizations and governments to understand climate risk, and take effective adaptation actions to reduce it.

There are two types of climate risk that companies need to be aware of: physical climate risk and transition climate risk – each with its own drivers, challenges and consequences for organizations.

What is physical climate risk?

Physical climate risk describes the potential for physical damage and financial losses as a result of increasing exposure to climate hazards resulting from climate change. It takes into account both the direct physical impacts of climate change (such as floods destroying infrastructure), and direct and indirect socioeconomic responses to climate change (such as losses caused by direct damage to assets which prevents their operability, and the costs of repairing that damage).

Physical climate risks can be either shocks or stresses. Shocks – such as floods, storms or wildfires – are immediate, destructive and relatively short-lived. Stresses are slow in their onsets, such as changes in precipitation, rising temperatures and seasonal shifts. These sustained shifts in climate patterns can have long-term effects on supply chains, property value and insurability. The Task Force on Climate-related Financial Disclosure (TCFD) describes climate shocks as acute risk, and climate stresses as chronic risk. Their impact can be gradual, but escalate over time. Many cannot be reversed.

Climate shocks are “occurring with greater frequency on both a regional and global basis”. Climate shocks and stresses can occur at the same time and impact each other, creating compound risks and cascading failures. For example, coastal flooding risks (climate shock) are exacerbated by sea-level rise (climate stress). As climate change accelerates, overall physical climate risk will continue to grow, often in non-linear ways – making it complex for organizations to adequately understand and plan for. Yet the costs of not doing so are severe: “the socioeconomic impact [of physical climate risk] increases between roughly two and 20 times by 2050 versus today’s levels,” says McKinsey.

Examples of physical climate risks

Physical climate risks include shocks such as:

  • Flooding (including river flooding resulting from excessive rainfall or meltwater, surface water flooding or flash flooding caused by extreme rain, and coastal flooding arising from high tides and strong winds or storm events)

  • Wildfires

  • Extreme wind events (including hurricanes, cyclones, typhoons and gales)

  • Extreme heat events

  • Extreme cold events

  • Drought

Physical climate risks also include stresses such as:

  • Changes to local rainfall patterns over time - increased or decreased rainfall

  • Water scarcity

  • Sustained shifts in average temperatures and humidity

  • Sea-level rise

Calculating physical risk: hazards and vulnerabilities

According to the Intergovernmental Panel on Climate Change (IPCC), physical risk “results from the interaction of vulnerability, exposure and hazard.” It is the combination that reflects the complexity of a person’s, community’s or organization’s exposure (how likely they are to experience) to hazards (climate phenomena that can cause damage), factoring in their vulnerability (how well-equipped they are to withstand a climate event).

Not all locations or assets will experience hazards in the same way, or to the same extent.

Take the hazard of heatwaves in cities. Cities that are built to adapt to extreme temperatures, like Abu Dhabi where cooling techniques are built into the architecture, will cope differently to cities like London, where many aging apartment towers are poorly ventilated and vulnerable to overheating. When extreme precipitation hits a city, the risk of flooding depends on the capacity of the city’s drainage system to cope with the overflow. Chicago has built ‘permeable pavements’ to cope with increasing precipitation, and Tokyo has built huge storage tunnels underneath the city to capture flood waters. However, heavy rainfall in Mumbai can bring the city to a standstill, and New York City’s drainage system was overwhelmed during Hurricane Ida in 2018. Physical risk analysis takes this complex interplay into account.

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What is transition climate risk?

Transition climate risks are business risks related to a transition away from fossil fuels and other greenhouse gas (GHG)-emitting activities. Decarbonization is critical to stabilizing the climate long-term, a process which will result in social, political and economic changes. The cost of decarbonizing assets and operations is a transition risk, yet businesses that fail to decarbonize also face other types of transition risk such as reputational loss, loss of market share and regulatory consequences.

The energy sector is at the nexus of transition risk. About 80% of the world’s global energy use today is produced by fossil fuels. The rapid transition away from these energy sources by mid-century creates transition risks for organizations that produce or rely on them. Energy producers face the dwindling value of their fuel reserves, and their infrastructure such as pipelines, drilling rigs and power plants risk becoming stranded assets. Downstream, businesses that rely on fossil fuel products or energy sources run the risk of disruption to their supply chains and operations.

Examples of transition climate risks

Transition climate risks include:

  • Stranded assets and depreciation e.g. reduced value of energy inefficient buildings

  • Increased capital expenditure e.g. from upgrading equipment or insulating buildings

  • Reduced consumer demand

  • Loss of market share

  • Increased costs e.g. from impacts to supply chain, or the costs of raw materials

  • Legal liability from failing to comply with regulatory requirements

  • Financial risk e.g. lack of insurability, or lack of access to finance, resulting from failure to comply with more stringent policy

The connection between physical and transition risks

Physical and transition risks are inextricably linked. As physical risk increases, so too does transition risk. As the physical risk of extreme heat events rises, so do the costs of either action or inaction – transition risk is inherent in either choice.

Owners of a manufacturing plant at high physical risk of heat waves can either adapt their asset, or continue business as usual. If they choose to adapt, the associated costs of relocating and retrofitting the asset represents a transition risk to the business that must be taken into account. If they choose not to respond to their physical risk, they face loss of revenue arising from reduced workability or operability, and the depreciation of their asset as competitors adapt.

Only by considering both the physical and transition risk to their assets across different time periods and climate scenarios can organizations make fully informed decisions about how best to protect their business from inevitable climate-related risk.

Mapping climate risks

Businesses can use scenario analysis to ask the question “what if…?” and explore how climate impacts might affect the resilience of the organization’s business model and strategy if it were to operate in that given scenario. Climate scenarios help organizations to understand their climate risks, and how they could evolve over time, to help them make informed strategic decisions about the future of their business and assets.

Climate scenarios are “analytical tools used to explore the potential impacts of climate change under different socioeconomic conditions, as well as to understand how human development and associated emission pathways affect the natural world,” explains Cervest’s Dr. Helen Beddow. “They help business leaders to make informed decisions by considering multiple different future climate possibilities and impacts, and allow them to better create strategies to mitigate damage to their assets and adapt.”

Different scenarios exist for modeling physical risks and for modeling transition risks. Climate scenarios based on earth systems modeling are used to understand the physical risks posed by both shocks and stresses. Scenarios for exploring transition risk use a simpler climate model that takes energy markets and how they function into account.

To form a good idea of the range of likely risks they face, organizations should use climate scenarios to explore their climate risk under at least three possible futures. Simultaneously they should consider how these risks play out over different time periods and how they manifest as individual climate hazards. Following information from the IPCC, these possibly futures should include:

  • Business as usual (Emissions continue to rise throughout the 21st century with no further policy intervention - the worst-case scenario for emissions)

  • Emissions peak in 2040 (Emissions that do not increase beyond 2040 - the middle-of-the-road scenario)

  • Paris-aligned (Emissions are reduced in line with the Paris Agreement, which aims to keep global temperature increases to well below 2ºC and preferably 1.5ºC - the best-case scenario)

By using climate scenarios to understand their physical and transition risks, businesses are better equipped to make critical decisions about where to allocate their resources to protect their bottom lines.

How climate intelligence can help you understand your climate risks

EarthScan™, Cervest’s climate intelligence product, represents a step change in organizations’ ability to analyze, understand and act on their climate-related risks. Uniquely dynamic, asset-centric and easily shareable, EarthScan creates climate intelligence (CI) at a decision-useful scale: across individual built assets, and entire portfolios of assets, an organization owns, manages or relies upon.

Ordinary climate analysis alone “is not particularly helpful… unless these risks can be further granulated in terms of their scope and, more importantly, their timing and likelihood,” says the Center for Climate Finance and Investment. Cervest’s climate intelligence does exactly that, allowing decision-makers to rate, report and manage their assets’ climate resilience, and offering asset-level insights to strengthen decision-making.

Unlike traditional data capture and analysis of climate risk, which tends to be retrospective, Cervest’s CI combines historic climate data with forecasting tools such as scenario analysis and planning. This creates an unprecedented and accurate picture of vulnerability, climate risk and resilience that organizations can confidently build a risk management strategy upon.

Cervest’s CI is made possible by Earth Science AI™, which fuses advanced science, data modeling and machine learning (ML) technology to translate complex, fragmented climate data into decision-useful climate intelligence. This includes EarthScan Ratings, a globally standardized and comparable measure of climate risk at the asset-level.

With EarthScan’s climate intelligence, organizations are able to see and act on their climate-related risks with clarity and confidence. As the climate becomes increasingly erratic, it provides the foundation they need to not only protect their immediate portfolio or supply chain’s assets, but also our greatest shared asset - the planet.

To find out more about how EarthScan can help you understand your climate risk, sign up today.

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