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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Series
- Sprache: Englisch
Assess the likelihood, timing and scope of climate risks In Climate Risks: An Investor's Field Guide to Identification and Assessment, financial analyst Bob Buhr delivers a risk-based framework for classifying and measuring potential climate risks at the firm level, and their potential financial impacts. The author presents a "climate risk taxonomy" that encompasses a broad range of physical, transition and natural capital risks that may impact a firm's financial profile. The taxonomy presented in the book will be of interest to investors and lenders involved in: * The identification and assessment of the potential scope and impact of a wide range of risks that might normally remain outside of more traditional risk or credit analysis, usually for horizon issues; * The determination of the points at which climate risks may crystallize into real and significant financial exposure * The assessment of the relative aggregate riskiness of portfolios exposed to climate and natural capital risks at the firm level A rigorous and practical toolkit for the assessment and measurement of a broad range of potential climate risks, this book offers fund managers, portfolio analysts, risk experts, and other finance professionals a clear blueprint for assessing potential financial impacts at firms arising from climate change.
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Veröffentlichungsjahr: 2023
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Table of Contents
Cover
Title Page
Copyright
Dedication
Preface
CHAPTER 1: Introduction: Why We Need a Risk Taxonomy
NOTES
CHAPTER 2: What Should a Climate Risk Taxonomy Do?
DEFINING RISK
GREEN TAXONOMIES
OTHER GREEN TAXONOMIES
PROPOSED RISK FRAMEWORKS
NOTES
CHAPTER 3: The Climate Risk Taxonomy and Its Constituents
RISK CLASSIFICATIONS
THE TAXONOMY RATIONALE
PHYSICAL RISKS
TRANSITION RISKS
NATURAL CAPITAL RISKS
ASSESSING RISK
NOTES
CHAPTER 4: Physical Risks
ACUTE RISKS
CHRONIC RISKS
WATER STRESS
HEAT STRESS
SEA LEVEL RISE
EXTREME PRECIPITATION
EXTREME WEATHER (ACUTE AND CHRONIC)
SOCIOECONOMIC VULNERABILITY
OTHER POTENTIAL RISKS
IMPLICATIONS FOR SELECT SECTORS
NOTES
CHAPTER 5: Adaptation Risks
ADAPTATION TO PHYSICAL CLIMATE RISKS
WHAT SORT OF INFRASTRUCTURE ARE WE TALKING ABOUT?
ADAPTATION, RESILIENCE, AND SUSTAINABILITY—SOME DEFINITIONAL ISSUES
TARGETING ADAPTATION COSTS
WHAT WILL ADAPTATION MEASURES ACTUALLY COST?
WHAT SORT OF FUNDING REQUIREMENTS ARE WE TALKING ABOUT, AND WHO IS AT RISK?
ASSET VALUATION RISKS
OPERATIONAL IMPAIRMENTS
COST OF BUSINESS ADJUSTMENTS
REGULATORY CHANGES (LAND USE AND ZONING)
LOSS OF SUBSIDY RISKS
IMPLICATIONS FOR SELECT SECTORS
NOTES
CHAPTER 6: Mitigation Risks
THE MITIGATION RISK TAXONOMY
THE LINK BETWEEN MITIGATION COSTS AND GHG REDUCTION
REGULATORY RISKS
TECHNOLOGY RISKS
GOING‐CONCERN RISKS
SUPPLY CHAIN RISKS
WATER RISKS
LOSS OF SUBSIDY RISKS
POTENTIAL COST OFFSETS
A COMMENT ON TIPPING POINTS
NOTES
CHAPTER 7: Natural Capital Risks
RESOURCE DEPLETION
SUBSIDY REGIME CHANGE RISKS
BOUNDARY CONDITION RISKS
GEOPOLITICAL EVENT RISKS
IMPLICATIONS FOR SELECT SECTORS
GLOBAL HEATING IMPACT ON NATURAL RESOURCES
NOTES
CHAPTER 8: Concluding Observations
NOTES
Selected Bibliography
Organizational Information
Acknowledgments
About the Author
Index
End User License Agreement
List of Illustrations
Chapter 1
FIGURE 1.1 United States' billion‐dollar disaster event count.
FIGURE 1.2 United States' 2022 billion‐dollar weather and climate disasters....
Chapter 2
FIGURE 2.1 Granulation of EU sustainable taxonomy physical climate risks....
FIGURE 2.2 CBI's taxonomy categories and status.
FIGURE 2.3 Average percentage of climate risk disclosure by industry.
FIGURE 2.4 TCFD flow of climate risks and opportunities to financial risks....
FIGURE 2.5 The NGFS framework for the transition from environmental to finan...
FIGURE 2.6 WRI/UNEP framework for addressing carbon risk.
Chapter 3
FIGURE 3.1 S&P credit frameworks (2013 and 2015).
FIGURE 3.2 The basic risk taxonomy.
FIGURE 3.3 Deriving a climate‐risk‐adjusted firm model.
Chapter 4
FIGURE 4.1 Physical risk taxonomy.
FIGURE 4.2 Number of catastrophic events, 1970–2019.
FIGURE 4.3 Insured vs. uninsured losses, 1970–2019.
FIGURE 4.4 AQUEDUCT model of global water stress.
FIGURE 4.5 Range of assessed scenarios and 21st‐century global warming.
FIGURE 4.6 Mean temperature forecasts and assessments of above‐average tempe...
FIGURE 4.7 Contributors to global sea level rise 1993–2018.
FIGURE 4.8 Sea level change 1993–2021 is not evenly distributed.
FIGURE 4.9 Rise in extreme weather disasters in the United States.
FIGURE 4.10 Economic losses from extreme weather.
Chapter 5
FIGURE 5.1 Proposed adaptation risk taxonomy.
FIGURE 5.2 Climate flow of funds 2019/2020.
FIGURE 5.3 Adaptation flow of funds 2019/2020.
FIGURE 5.4 Summary of typical risk types and asset classes associated with e...
FIGURE 5.5 Sectors and countries represented in the OECD subsidy analysis....
FIGURE 5.6 US electricity facilities less than four feet above local high ti...
Chapter 6
FIGURE 6.1 Proposed mitigation risk taxonomy.
FIGURE 6.2 Greenhouse gas emissions by sector, 2016.
FIGURE 6.3 US manufacturing energy consumption by sector.
FIGURE 6.4 Final energy consumption of the industry in EU‐27 in different in...
FIGURE 6.5 Global greenhouse emissions by gas.
FIGURE 6.6 Global methane emissions by source.
FIGURE 6.7 Annual CO
2
emissions, 1800–2019.
FIGURE 6.8 Illustrative energy price impacts for a US $50 carbon tax p/tCO
2
e...
FIGURE 6.9 Tracking countries' goals versus actual reductions.
FIGURE 6.10 Energy efficiency milestones in the “Net Zero Emissions by 2050 ...
FIGURE 6.11 Industry‐specific relative contributions to deep decarbonization...
FIGURE 6.12 Electric car costs will not fall in line with combustion engines...
FIGURE 6.13 How we get cement.
FIGURE 6.14 Metals used in clean energy technologies.
Chapter 7
FIGURE 7.1 Proposed natural capital risk taxonomy.
FIGURE 7.2 SRI proposed boundary conditions.
Guide
Cover Page
Title Page
Copyright
Dedication
Preface
Table of Contents
Begin Reading
Selected Bibliography
Organizational Information
Acknowledgments
About the Author
Index
Wiley End User License Agreement
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Climate Risks
An Investor's Field Guide to Identification and Assessment
BOB BUHR
This edition first published 2023
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For my family, Jenni, Megan, and Susan, and my grandkids, on whose behalf saving the planet seems like a good idea.
Preface
Occasionally, and usually against my better judgment, I look at the comments in The Financial Times on their wide range of climate coverage (which is generally excellent). I do this to check to see whether the denial and indifference to the notion of anthropomorphic climate change that seems to afflict so many FT readers, not to mention the financial community in general, is still with us. Sadly, it still is. However, this denial and indifference appears to be on the decline, although it's not gone yet. This is purely an anecdotal judgment, of course, but I would like to think it is also true.
This optimistic observation needs to be tempered by the fact that much of the political world, and that of public policymakers, has not yet caught up to climate reality. But investors and lenders, as well as a wide range of regulatory agencies, seem to be moving to an increased understanding that we may just be facing an existential crisis. We are not all Extinction Rebellion activists yet, although many of us are finding ourselves in the same ballpark at this point. Andreas Malm's stimulating How to Blow Up a Pipeline encapsulates some of the dilemma this presents—if you're facing an existential crisis, what sort of actions are appropriate?
In our case, we can at least try to get the numbers right. And that activity encompasses assessing the range of risks that are inevitably going to rise, and that will need to be dealt with. And at what cost will they be dealt with? In many cases, this is still contingent on public policymakers. They will certainly be in the trillions of dollars in the aggregate—but for most people, including those in the financial sector, as soon as one starts discussions of trillions of US dollars (or Euros, or pounds sterling), an air of unreality sets in. What do these numbers even mean? We can at least identify where the relevant financial risks are likely to materialize, and under what circumstances, and granulate these costs, to the extent possible, to real firms. This is our job, and what we are supposed to be good at.
This entire volume is premised on the notion that if we, as financial analysts and those who use such analysis, can deal with analyzing traditional business and financial risks successfully (which has generally been the case), we should be able to expand our horizons to encompass a new and significant class of risks—some of which, actually, are not so new. As is becoming increasingly clear, these risks are not trivial—they are increasingly systemic, and increasingly scary. Hopefully, this volume may make that process a bit more straightforward.
London,November 2022.
CHAPTER 1Introduction: Why We Need a Risk Taxonomy
The year 2022 has been another year of major economic upheaval due to the continued escalation of climate change (mainly global heating) impacts, most noticeably as natural catastrophes. The catalog of physical risks on display is considerable. Numerous droughts either continued or emerged: in the American Southwest there has been a record heatwave (over the past twenty years); a drought in China; a record drought in Chile; and a Northern European drought so severe that water levels in the Rhine dropped so much that river traffic, a critical element in Germany's export‐dependent economy, was essentially blocked for several weeks. Water levels in rivers worldwide dropped to record or near‐record levels, including in the western United States and China, and even the River Po in Italy and other areas in Europe.
Not to be outdone as a disaster category, record flooding in Pakistan, India, and Nigeria displaced tens of millions, produced significant amounts of topsoil loss and land destruction, and impaired crop production in many countries dependent on agricultural exports (not to mention serving domestic agricultural needs). In addition, significant flooding in Australia (again), parts of Brazil, and portions of the eastern United States (again) had significant negative economic impacts. Flooding associated with Hurricane Ian has proved to be Florida's largest economic disaster ever. The increase in flooding in Africa is particularly worrisome given the still‐high dependence on local agricultural resources in many countries. The increased severity of extreme weather events is another concerning phenomenon. Japan, the Philippines, and Pakistan were each the victims of record or near‐record‐intensity storms over the course of the year.
At several points during the first nine months of the year there were so many simultaneous major extreme weather events around the world that one had to check to make sure whether one was reading about an existing disaster, or a new one. But extreme weather is simply the most obvious manifestation of the potential impacts of global heating.1 Other less dramatic, but perhaps more significant, events and processes continued unabated. Glacial melt in both Greenland and Antarctica accelerated in both regions—these are the largest glacial areas in the world, and ice continues to disappear (turning into either water or water vapor) in both regions, with potentially major impacts on the earth's air and water circulation systems. Deforestation in critical forested areas—the Amazon, Africa, Southeast Asia, and northern areas such as Russia, Alaska, and Canada—continues through human activity, but also increased wildfires. Multiple places were subject to extremely hot temperatures, particularly India, Bangladesh and Pakistan, but also western China, which saw its worst heatwave in recorded history.
The human costs are, in terms of land displacement alone, significant, and will likely continue to rise. The current century is expected to be one of increased global migration on the back of environmental, usually climate‐related, events and processes that will make portions of the planet increasingly unlivable for humans. Political and social conflicts relating to potential resource availability and scarcity issues are expected to increase. There is already evidence of intensifying competition for water resources in a number of places around the world, for example. The current rate of topsoil depletion suggests that topsoil could become another area of concern over scarcity. Climate impacts are expected to intensify competition for increasingly scarce natural resources.
Moreover, in October 2022 the United Nations Framework Convention on Climate Change (UNFCCC) issued a synthesis report indicating that signatories to the 2015 Paris Agreement are lagging considerably in meeting their climate commitments.2 As noted in the report,
The best estimate of peak temperature in the twenty‐first century (projected mostly for 2100 when temperature continues to rise) is in the range of 2.1–2.9 °C depending on the underlying assumptions.
This is, of course, considerably higher than the 1.5 °C target agreed to in the 2015 Paris Climate Agreement, mainly because most signatories have not been meeting proposed Nationally Indicated Commitments. We are losing ground, in other words.
Thus far 2022 has also highlighted another disturbing trend, particularly for investors and lenders—the negative impacts of global heating are costing more than they did ten years ago. The impacts here are broad‐based, ranging from individual homeowners to municipalities to state and national governments and, of course, businesses of all size, and their insurers. The US National Oceanic and Atmospheric Administration (NOAA) has noted that for the United States alone the number of “billion‐dollar natural disasters” through nine months of 2022 is running well above its historical average, and in fact appears to parallel years of all‐time highs (although as NOAA points out, the financial impact has been below 2021, and the record year of 2017). The trend for this is shown in Figure 1.1.
FIGURE 1.1 United States' billion‐dollar disaster event count.
Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, 2022.
As Figure 1.2 shows, the range of disasters is relatively broad, encompassing extreme weather, drought, and flooding in particular.3
On a global basis the narrative is fundamentally similar. As Swiss Re has noted,4
The rise in insured losses maintained a long‐term trend (based on 10‐year moving averages) of 5–7% growth annually. Once again, secondary perils, including floods, were at the forefront, accounting for more than 70% of all insured losses. It was the first year ever that two separate secondary perils events—winter storm Uri in the US and the flood in western/central Europe in July—each caused losses in excess of USD 10 billion.
The impacts of these events, most of which are flood related, are socially and economically very broad‐based, and in some parts of the world potentially catastrophic in terms of, for example, topsoil lost in excessive flooding.5 For investors and lenders, the impacts will not be nearly as draconian. Nonetheless, there is a broad spectrum of potential financial impacts that may range from asset value destruction to revenue and profitability losses, reduced tax revenues for governments, and higher insurance losses and costs.
FIGURE 1.2 United States' 2022 billion‐dollar weather and climate disasters.
Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, 2022.
For a number of observers, then, these developments have more than a passing import. Investors, lenders, and financial regulators are paying increasing attention to these potential costs, and to the risks underlying them. Unsurprisingly, this is largely because it has become clear that these costs will continue to rise as the impacts of global heating continue to grow. This has resulted in multiple initiatives to try to capture and organize the factors driving these costs, of which the Task Force on Climate‐related Financial Disclosures (TCFD) is probably the best‐known example.6 (We will discuss these recommendations, and others, in more detail in Chapter 2.) This has also led to considerable work on cataloging those areas where investors and lenders can help facilitate a transition from our currently carbon‐dependent economy to an energy system considerably less reliant on carbon energy sources, particularly with an overall target of reducing Greenhouse Gas (GHG) generation by firms and sovereign entities. The EU's Sustainability Taxonomy is perhaps the best‐known example of this.7 We note that much of this work has taken the form of more detailed and robust tracking of GHG emissions.
However, as we hope to make clear in this book, climate risk identification, assessment, and reporting may encompass a substantially broader landscape than simple reporting of GHG generation on an annual basis. For investors and lenders, climate change represents a medium‐ to long‐term trend with the potential to have wide‐ranging financial impacts on companies in a range of potentially affected industries, including on their credit profiles and/or share prices—or, indeed, their continued going‐concern status. However, this knowledge is not necessarily helpful for lenders, investors, or regulators unless these potential risks can be granulated and quantified in terms of their scope and, more importantly, their timing and likelihood. A sufficient granulation of the potential risks being discussed here, along with some assessment of likelihood and timing of potential impacts, will facilitate an assessment of their specific financial manifestations, be it cash flows, asset valuations, margin impacts, or credit ratios, for example.
Moreover, increased concern among lenders, investors, and regulators over potential climate risks and some of the uncertainties associated with these risks has highlighted the need for a more rigorous assessment of just what those risks actually are.8 This concern is being driven by two factors:
the increased frequency and severity of the impacts of global heating, particularly over the past decade, and
the increased likelihood of the need for the reporting of the potential impacts of these risks by firms.
9
We have recently seen the emergence of various “Green” taxonomies, which largely reflect public policy objectives of facilitating financing for an energy transition to a zero‐carbon economy. However, while “green taxonomies” classify the investment opportunities that may arise in a transition to a low‐carbon economy, they often fail to capture and granulate the risks, and in particular the costs, associated with this shift.10 These taxonomies are not designed to quantify specific risks and their impacts, of course—that's not what they were created for. Nonetheless, the need for a framework for such risk evaluation is obvious. One of the aims of climate risk analysis is identifying potential firm‐specific climate risks before they cause reductions in asset utilization, stranded assets, reduced income and margins, impairments to cash flows, or other financial impacts.11 These potential risks embody changes that translate into increased financial and credit risks, and these are likely to influence lenders' and investors' decisions about financial profiles.
Accordingly, this book presents a framework for classifying potential climate risks at the firm level, a climate risk taxonomy that captures a broad range of possible (and, in some cases, likely) physical and transition risks. Note that this book is a not an inventory of these potential risks as they currently present themselves—rather, it is a potential framework for identifying where those risks are likely to materialize as climate change impacts become more significant. The main advantage of such a comprehensive climate risk taxonomy is that it would enable banks, investors, and regulators (including central banks) to assess the relative aggregate riskiness of portfolios that derive from climate and natural capital risks at the firm level. By financial risks, we specifically mean those financial events or trends that may affect, for example, a company's probability of default (PD), its credit rating, its share price, or its ability to internally fund necessary CAPEX (capital expenditure) because of a change in some critical financial measures (asset valuations, cash flows, leverage ratios, reserve levels, and margins being the most critical). Another advantage is that such a taxonomy can be built up using existing risk assessment frameworks and categories, as we will show.
Investors and policymakers have settled into a convention that subdivides potential climate risks into two traditional broad categories: physical risks and transition risks. Physical risks represent the range of impacts on landforms and infrastructure that will result from physical results of climate change—increased heat in certain regions, increased flooding from storm surge, and a range of other physical impacts. Transition risks are generally categorized into two further categories: adaptation and mitigation. Adaptation responses are designed to cope with the probable physical, societal, and economic consequences of global heating on populations and regions, particularly on infrastructure. Mitigation measures generally are designed to curtail the growth of GHG emissions, principally CO2 and methane.
The granular taxonomy presented here encapsulates potential climate risks in terms of these three traditional climate risk categories, and also includes an additional category, natural capital risk. The overall framework, then, is as follows:
physical risks, both acute and chronic risks (and often both at the same time);
transition risks related to adaptation policies in response to physical risks;
transition risks related to mitigation, ranging from regulatory compliance risks to reputational and litigation risks; and
natural capital risks, which reflect mainly depletion of both renewable and nonrenewable resources that are themselves affecting, and being affected by, potential climate risk factors.
The objective of this comprehensive climate risk taxonomy is that it enables lenders, investors, and regulators to assess better the relative aggregate risk exposure of portfolios that derive from climate and natural capital risks at the firm level. Moreover, the categories and indicators presented here are, we believe, more granulated than those suggested in other models. They are certainly broader—most of the climate frameworks currently in effect take GHG emissions as the main risk to be solved. We hope to show that this is insufficient. Climate risk disclosure entails considerably more than simply cataloguing reductions in GHG emissions. The importance of developing this model for the analysis of firms is simply that the firm is what an investor invests in, either directly or indirectly (through index funds, for example). The firm is also what a lender lends to. Lenders do not lend to the chemical sector—they lend to individual firms in that sector.
We note that numerous entities undertaking climate risk analysis—financial analysts and rating agencies, for example—have been somewhat constrained in their analysis of potential climate risks by two factors:
the very limited historical base for many of these risks; and
the potentially uncertain horizons or impacts, many of which lie outside traditional analytical or rating horizons.
The first point is obvious. While some of these impacts have manifested themselves repeatedly through the planet's history, very few of them have posed material challenges for the survivability of humanity over the past 10,000 years, including the past several hundred years of industrial development on a planetary scale.
The second point is a bit more complicated. Potential climate risks pose a challenging issue for determining risk horizons, which is a central component of the financial analysis usually undertaken by investors and lenders. Specifically, potential climate risk may have a very high level of likelihood, but their timing and scale may both be uncertain, particularly regionally in terms of physical risks such as sea level rise. We know that sea level rise will have a range of significant regional impacts—but we may not know when these physical impacts will have financial implications, or at what scale. A fundamental issue with climate risk analysis, then, is dealing with these uncertainties. In many cases, particularly with reference to adaptation and mitigation risks (both being transition risks), the potential scope of these risks is contingent on public policy decisions.
The climate risk taxonomy presented here is essentially a toolkit for firms, and people who analyze them, to identify and assess the potential scope and impact of a wide range of potential risks that would not necessarily appear in more traditional risk or credit analysis. Importantly, the taxonomy presented here is intended to supplement, not replace, traditional financial analysis, which is useful—indeed, fundamental—for assessing situations with more determinate horizons. More specifically, a climate risk taxonomy should be organized according to increasing granulation of different types of risks and levels of potential materiality at the firm level. The EU's Green Taxonomy is a useful tool to define an investment opportunity set. However, it is limited in its potential utility as a risk monitor, partly because of its focus on industrial sectors, rather than firms, and partially because it generally does not assess the costs associated with the transition it seeks to encourage. The EU taxonomy is an excellent guide to investment, and is not unmindful of climate risks, but it is not necessarily a framework for risk assessment. There are, in fact, a number of potentially useful taxonomies for risk assessment that have emerged in recent years, but all have some limitations We note that the taxonomies proposed by Climate Bonds Initiative (Climate Bonds), the Sustainability Accounting Standards Board (SASB), and the Carbon Disclosure Standards Board (CDSB, now the ISSB)12 have all proposed frameworks for assessing varying degrees of compliance with Paris Climate goals that are also useful for consideration of various levels of risk.13 However, none have been developed as strictly a risk‐based taxonomy.
There is, out of necessity, a wide range of risk categories being considered, and many are quite different from each other. Sea level rise is not the same sort of risk that carbon taxation is, although both have the potential for sizeable financial impacts on firms and their instruments. Since the proposed taxonomy is primarily designed to address potential risks attending to individual instruments—loans, bonds, and equities—we have sought to granulate risks to the level at which these risks have the potential to have a financial impact. This is, of course, partially a speculative exercise, but hopefully one informed by what experience we have with these potential risks to date.
In fact, since there is no pre‐existing climate risk taxonomy for firms, we have had to create one. The specific categories chosen—physical and transition risks, the latter further granulated into adaptation and mitigation risks—are generally those found in any compendium of climate risks, although not all of these are organized along the same lines. Natural Capital Risks, on the other hand, represent, to our knowledge, an entirely novel taxonomy, although with the sharpened attention to biodiversity among investors and lenders we suspect it will take on increasing importance. Moreover, as we discuss in Chapter 2, the overall framework we have used for providing a context for this risk analysis is the traditional risk model employed by financial analysts over the past several decades.
The Physical Risk category in particular is the one that has been explored most thoroughly, for several reasons, particularly by the Intergovernmental Panel on Climate Change (IPCC). First, it is relatively straightforward—there is considerable overlap and duplication of categories across groups in their adoption of the specific categories. Second, these are the areas where potential financial risks are manifesting themselves most obviously at present. The categories presented here reflect a distillation of a broader range of risk and hazard categories. Our major risk categories are heat stress, water stress, extreme precipitation, sea level rise, and extreme weather. Other approaches may have a different number of general categories, but the overall scope of the analysis is essentially the same. There are actually only a limited number of possible physical risks categories that lend themselves to this approach, and only a limited number of ways to describe them. We have not necessarily included all physical risks—only those that are likely to manifest themselves as financial impacts at the firm level. We also retain the traditional distinction between acute and chronic physical risks: acute risks refer to episodic events that have the potential to inflict significant physical damage (e.g., wildfires, river and ocean flooding, and tropical storms), while chronic risks have a considerably longer duration (e.g., sea level rise and increases in global mean temperature) and may be understood as processes rather than events.
What investors and lenders are facing is the fact that what have traditionally been classified as idiosyncratic risks—natural disasters, for example—are becoming less idiosyncratic and more systemic. While the number of manmade disasters (aviation and maritime, for example) has declined from their high in 2005, natural catastrophes (particularly those associated with severe storms and flooding) continue to rise,14 and this rise is attributed to global heating impacts. While most industries will have some exposure to physical risks, there are some industries that will have considerably more exposure than others. Since a considerable portion of humanity lives along the coast or on banks of rivers, and these are where the bulk of global economic activity takes place, it would be cavalier to assume that the impacts of the manifestations of these risks will not be felt broadly. Particular sectors at risk include: infrastructure, particularly utilities and ports; residential and commercial (including industrial) property; transport; financial institutions; and insurance.
This raises an issue that will likely arise during any risk analysis of physical risks—the potential for stranded assets. There is also the broader question of whether valuation of the firm is directly dependent on the valuation of its physical assets. Most industrial firms are not dependent on a single physical asset. However, there are sectors where there is a rationale for a particular physical location, or a concentration of them. For example, utilities are almost always located adjacent to bodies of water—be it the sea or rivers. Mines are located where the resources are to be found. It is also possible that physical assets in the aggregate may present risks that, individually, would be immaterial as a single property. This may be the case for property portfolios—single property risks may be small, but in the aggregate these risks may become potentially material for lenders and/or investors.
Discussions of modeling and scenario analysis lie outside the scope of this book, although these are now regarded as integral tools for assessing the potential impacts of climate factors (in particular, global heating) on firm evaluations. Though the classification of physical risk categories is relatively straightforward, there are nonetheless several issues that make modeling these risks a complex process, even as they are becoming increasingly important in climate risk analysis. Critically, it is important to recognize that potential climate risks are not necessarily independent of each other—there is no such thing as orthogonal climate risks. The potential extent to which feedback loops may need to be included in any sort of modeling is a complex issue, but to some extent these will be model‐ and scenario‐specific, and potentially significant. What this book outlines are those potential risks that should be the subject of scenario analysis—if the appropriate risk categories are not being modeled, then it is not clear what purpose the analysis serves.
Adaptation risk categories are also relatively consistent, since the physical changes expected to emerge are well identified, so issues associated with adapting to these impacts should be also well understood, at least conceptually. However, we note that there have been only moderate attempts to codify these potential risks in the climate risk literature, unlike, for example, the urban planning literature. This category, then, represents a constructed set of risks that seem most directly relevant to the Adaptation process and its potential costs. This category also entails some discussion of resilience, which is often used as a target to which adaptation should aim to achieve. This will be discussed in more detail in Chapter 5.15
We note that most of the specific potential adaptation risks outlined here derive directly from specific risk indicators used in traditional financial analysis. All five of our categories—Asset Valuation Risks, Operational Impairments, Cost of Business adjustments, Regulatory Changes, and Subsidy loss risks—are categories assessed in the normal course of determining the credit risk of any potential investment, for example. We have chosen these as being the areas where specific potential risks relating to adaptation efforts are most likely to manifest themselves. Note also that two of the adaptation risk categories—Subsidy Loss Risk and Asset Valuation Risk—appear more than once in the overall taxonomy. This will be a recurring issue—specific financial risks can result from more than one potential climate impact.
Adaptation costs, and who will bear them, are an important element of this assessment. Adaptation risks encompass the impacts of adapting to climate change on the physical environment, and the potential financial impact such risks may carry for individuals, governments, and corporations. Note that these risks may take the form of the costs associated with various adaptation actions—but there will also be potentially significant costs associated with inaction. Rising ocean levels and increased flooding will pose actual risks to coastal areas, for example, including port facilities and railroads. If left unmanaged, these risks have the potential to produce potentially significant asset devaluations, if not outright stranded assets. Adapting to these impacts, either by accommodation or displacement, is likely to entail substantial costs. At present, these costs, when actually incurred, are generally being borne by governments and insurance companies.
Of the Adaptation Risks discussed, the potential from Stranded Assets remains one of the most uncertain, but one with a potentially large tail risk. In part this reflects the uncertainty over the potential timing of Adaptation costs being expended—there is often a long lead time, but the costs may be significant in any event. For example, consider what might be involved in adapting transport systems (including the potentially necessary land infrastructure replacement, particularly rail). It will be some time before there is a better picture of what assets will be involved, or not, in significant adaptation impacts. However, current assessments are not comforting—a recent study has suggested that the fossil fuel industry may be facing a stranded assets impact of US $1 trillion.16
Loss of financial subsidies remains a significant potential risk as well, although one not generally discussed, since the political realities of cutting subsidies are complicated. Subsidy risks actually span three risk categories being discussed in this report: Adaptation, Mitigation, and Natural Capital risks. Subsidies generally enable economic producers and consumers to avoid paying the genuine economic costs of the extraction and usage of various resources. To the extent that subsidies contribute to financial indicators of interest to investors and lenders—earnings and cash flows in particular—any loss of these subsidies could prove to be financially punitive. Most industries actually receive a range of producer and consumer subsidies, but some industries—agriculture, fossil fuels, metals and mining, and construction—appear to be more significant beneficiaries of government generosity than others. In particular, agriculture could be significantly affected by major subsidy changes, especially those related to water availability. We are already seeing potential water conflicts in the Southwestern United States between farmers and urban residents over water allocation issues.17
There are numerous industries that have some degree of exposure to adaptation risks and their associated costs—in fact, most industrial firms have some physical exposure to potential climate impacts. These include utilities, property and real estate, energy, ports, transportation (particularly rail transport), refineries, cement and building materials, including steel, and manufacturers in a wide range of industries that benefit from the proximity to transit hubs. Potential exposure will clearly vary by country and by sector. In addition, industries with significant and occasionally complicated supply chains may also be vulnerable to these risks. We note that in some cases, sovereign government financial profiles could be negatively affected by adaptation costs, assuming they can be adopted. For numerous emerging markets (EM) sovereigns, this may not be feasible.18
The mitigation category being presented here has the least amount of external validation if that means aligning with other taxonomies. This is simply because there are no external taxonomies where these potential risks are articulated broadly above and beyond emissions reductions, although the respective taxonomies of SASB and CDSB include elements of various transition mitigation risks, and the TCFD indicates some suggested risk categories (all discussed in Chapter 2). The major exception is the area of “Energy Transition,” where many of these potential risks have received varying degrees of attention and where ongoing debates over appropriate future energy trajectories remain lively.19 As in the case of adaptation risks, we have generally adopted indicators of potential risk from more traditional credit analysis—again, there turns out to be a number of potential climate impacts that can be expected to manifest themselves in these various categories. Technology risks and litigation risks relating to climate risk both present interesting and potentially expensive issues—but these risk categories are pretty standard in any sort of financial analysis of firms.
While the mitigation risk category represents the most diverse collection of specific risks of the whole taxonomy, there is a recurring theme to these specific risk indicators, which we mentioned with respect to adaptation risks: their potential impact is directly derivative of human activity in response to potential climate impacts. Such costs are usually the result of public policy decisions adopted by governments and/or regulators, and these can change as well. There is a broad range of potential mitigation efforts being considered at various government levels, and some are even being implemented. Much of this activity has the potential to increase financial risk to firms.
Our principal risk categories in this collection are regulatory risks, technology risks, going‐concern risks, water risks, and subsidy risks (again). These categories encompass eighteen separate proposed risk indicators, but we have every expectation that this number will be revised at some point. Currently, the main mitigation risk is from the regulatory front, as regulation of carbon and other greenhouse gases seems increasingly likely and will certainly remain a topic of debate. Regulatory risks also encompass other potential regulatory measures, particularly those related to water availability and noncarbon pollution. Of the other risk indicators of this group, many have considerable uncertainty attached to them. In some cases, such as litigation, the risks may be simply binary: risks will either be low or high. In other cases, such as removal of subsidies or failure to maintain social license to operate, risks may be more industry specific. Many of these risks are already materializing, in some cases in surprising scale (e.g., the emergence of consumer demand for nonmeat products, which is having an impact on the food industry, or the enthusiasm for electric vehicles).
The range of going‐concern risks—risks related to simply running the business—is probably surprising, but these represent traditional risk categories that have been exacerbated by potential climate impacts. This group consists of commodity price changes, changes in consumer preferences, reputational and license to operate risks, litigation risks, and supply chain risks. We also note that this category can include a range of possible offsets. These may be industry specific—reforestation programs from the paper and forest products sector, for example. Many of these seem to involve carbon capture and storage (CCS) proposals, although we note considerable uncertainty remains as to whether this will be a successful approach to carbon offsets. We will discuss this point in our section on technology risks. Note that the recent surge in interest in “net‐zero” targets relies heavily on the use of these potential offsets.
Not surprisingly, the main industries potentially affected by mitigation risks are industries we have already encountered: transportation; metals, mining, and construction; and energy and utilities, including oil and gas. In particular, these are industries that rely on heat to generate their product—cement and steel, for example. We also note that the automobile industry is facing some industry‐specific transition challenges. We will discuss these in more detail in Chapter 6. Nonetheless, it is difficult to envision an industry that will not be engaged in mitigation and transition measures, even if it is only through supply chain disruptions, although sector costs may vary widely.
The fourth category in this taxonomy, natural capital risks, represents an entirely novel concept and, we believe, the first attempt to codify such risks into an organized taxonomy (although, we admit, a relatively simple one). While conceptually different from climate risks, many of these risks are currently being exacerbated by climate impacts, and in turn may be accelerating some potential climate risks—the impact of land use changes on the incidence of drought, for example, or of natural resource depletion in the case of declining water aquifers globally. In essence, these reflect potential risks to asset values, profitability, cash flows or margins from natural events that may be accelerated because of some form of natural capital depletion or disruption.
For example, the apparent increase in the number of droughts worldwide is having a short‐term impact on some industries (e.g., agriculture in California, supply chain issues in Germany). But droughts can also have longer‐term financial impacts, some of which are emerging in the Southwestern United States and portions of Mexico.20 In addition, these potential risks may have a geopolitical impact, as evidenced by many events in North Africa and the Middle East over the past decade, where climate impacts have had a role in economic affairs and social unrest. Many of these risks appear to be more frequent, more numerous, and perhaps more predictable than they used to be. In fact, there is every reason to believe that many natural capital risks will increase in intensity in the next two to three decades.21 Many of these risks also, obviously, encompass risks to human societies.
The four major natural capital risk indicators chosen—subsidy loss risks, depletion risks, boundary condition risks, and geopolitical event risks—are, in fact, all manifesting themselves at present, although these are less directly tied to specific firms than the other types of potential risks being discussed in this book. We believe these four general metrics accommodate the wide range of natural capital issues currently unfolding, many of which are receiving increased attention from investors—recent emerging concerns about biodiversity reflect this, as do concerns about metals required for electric vehicle batteries. As with both types of transition risks, several of these natural capital risks derive from multiple sources. Of particular concern is that numerous forms of natural capital—in fact, most—are being depleted more rapidly than they are being replenished, if they are renewable resources such as forests, fisheries, and farmland topsoil. Moreover, if we are referring to nonrenewable resources such as minerals and, perhaps, the capacity of the atmosphere and the oceans and atmosphere to absorb CO2 without untoward effects, the narrative becomes even more complex, but currently seems to be trending in the wrong direction.
We thus distinguish between renewable and nonrenewable depletion risks, given that these reflect two different types of resources. We also discuss water risks as being perhaps the most significant depletion risk. Water never goes away, it simply changes its state. And at present the trend is for much of the world's water to move from ice to liquid water to water vapor, accelerating the process of evaporation globally: “Water always wins.”22 Industries likely to be affected by either the continuation of current Natural Capital Trends, or efforts to moderate these trends, include most major global industries. All industries are dependent on water—but some industries are thirstier than others. While the global food system is the most likely to be affected in the near term, other potential candidates for disruption include: energy (principally oil and gas production); metals and mining; electric utilities; paper and forest products; and chemicals. Much of this risk exposure derives from industrial dependence on high levels of water consumption in the manufacturing process.
In addition to the above, we also cite the potential impact of global heating on the state of natural resources. In the case of global heating, the concern here is with the impacts of those physical impacts on other natural capital trends—particularly the depletion of forest, agricultural land, particularly topsoil loss trends, and other renewable resources. The desertification of parts of the world will likely be accelerated under more draconian global heating scenarios. Negative biodiversity impacts are expected to accelerate as climate change impacts become more severe.23 The cost of global deforestation to firms, mainly agricultural firms, may exceed $53 billion, according to CDP.24
While it is difficult to envision these trends manifesting themselves as firm‐specific financial impacts in the near term, other than water availability issues in some regions, especially for large, well‐capitalized corporations, the outlook for EM sovereign governments is considerably more uncertain. This is particularly the case for those dependent upon resource development and exports for economic growth. Agencies and organizations have addressed the issue of the possible impact of climate change on a range of EM sovereigns, particularly those with a high dependence on natural resource or agricultural exports, or those with substantial exposure to physical climate risks. These are sectors where the macroeconomic financial impacts are generally believed to be potentially negative.
In summary, the taxonomy being presented here is designed to improve the assessment of potential financial risks to firms posed by the physical and transition risks associated with climate change. Many of the specific categories chosen mirror those found in any compendium of climate risks, although not all of these are organized along the same lines. On the other hand, many had to be imputed based on traditional risk frameworks employed by financial analysts. All of these potential risks can be assessed within the general approach to risk undertaken by financial analysts, portfolio managers, and lenders.
It should be clear at this point that what we refer to as climate risks actually constitute a broad collection of risks of various types. Even more critically, climate risk can no longer be viewed as idiosyncratic risks that can be diversified away from. Rather, these are now increasingly regarded as systemic risks. Granulating these risks into a taxonomy can help us assess not only the specific impacts of those risks in isolation, but also the complex relations and overlap between them, more effectively. The potential for feedback loops here is high, and in many cases not well understood.
The assessment of the financial impacts of climate risks is as much an art as a science at present. In part, this reflects horizon issues; assessing risks that may not manifest themselves for several years, or even decades, is indeed a highly speculative process. However, there is the further complication that the emergence of most of these risks, at least the physical risks, is pretty much a certainty. We know that something is highly likely to occur, but we are not certain about the timing, or the scope. Droughts are likely to become more severe. Extreme weather is expected to become even more extreme in parts of the world. Sea level rise is likely to occur at an accelerating rate. We believe analysis of these risks should not be supplemental to fundamental risk analysis over the longer term. This sort of analysis should be integral to the financial analysis of firms.
Note that this book is not a set of recommendations or procedures on modeling or scenario analysis. It is more basic than that. This book is simply a review of the range of potential risks that may need to be considered when constructing these models and scenarios. Moreover, we make no claims as to the relative weighting of each of these potential risks should they arise from one sector to another. We believe industry analysts and lenders themselves are best positioned to distinguish between the climate risk profiles of, say, steel producers as opposed to those of supermarket chains. There will be overlaps; there will also be significant differences. Industry analysts are the best positioned group for those assessments. We hope that this book provides some useful tools for that process.
NOTES
1.
See, for example, Intergovernmental Panel on Climate Change (IPCC).
Fifth Assessment Report: Climate Change 2014: Impacts, Adaptation and Vulnerability,
2014;
Global Warming of 1.5
o
C, Summary for Policymakers
, 2018; Summary for Policymakers. In
IPCC Special Report on the Ocean and Cryosphere in a Changing Climate
, 2019;
The Concept of Risk in the IPCC Sixth Assessment Report: A Summary of Cross‐working Group Discussions; Guidance for IPCC authors
, September 2020;
Climate Change 2022: Mitigation of Climate Change, Working Group III—Contribution to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change. Summary for Policymakers
, 2022.
2.
United Nations Framework Convention on Climate Change.
Nationally Determined Contributions under the Paris Agreement: Synthesis Report by the Secretariat,
October 26, 2022.
3.
Note that NOAA's figures include Hurricane Ian, but not the financial impacts, which are still being developed. At the time that NOAA prepared this information (the first nine months of 2022) the cost of these disasters was relatively modest when compared to some years, particularly 2017. With Hurricane Ian shaping up to be the most expensive disaster in US history, these assessments will obviously change.
4.
Bevere, Lucia and Federica Remondi.
Natural Catastrophes in 2021: The Floodgates Are Open—Losses from Flood Have Been on an Upward Trend Globally
. Zurich: Swiss Re Institute, 2022.
5.
IPCC.
Climate Change 2022: Impacts, Adaptation and Vulnerability—Summary for Policymakers
, March 2022.
6.
Task Force on Climate‐related Financial Disclosures.
Final Report: Recommendations of the Task Force on Climate‐related Financial Disclosures
, December 2016;
Task Force on Climate‐related Financial Disclosures Status Report,
October 2021.
7.
EU Technical Expert Group on Sustainable Finance.
Taxonomy
:
Final Report of the Technical Expert Group on Sustainable Finance
, March 2020;
Financing a Sustainable European Economy Taxonomy Report: Technical Annex
, March 2020.
8.
