Climate Risk 14 May 2024
Climate scenario analysis – The building block of your climate strategy and transition plan
7 Min Reading Time
There is no doubt that we are already experiencing the impacts of a changing climate. Pick any year from the last decade and you will find plenty of extreme weather events which, without climate change, almost definitely would not have occurred or would not have been as intense. For example, the extreme temperatures experienced across Europe, North America, and China in 2023; the ongoing three-year drought being experienced in the horn of Africa; the catastrophic downpours in Libya which led to the collapse of three dams, causing more than 3400 deaths; and the exceptionally wet and stormy 2023-24 winter in the UK. Examples of human induced climate change can be found in any region in the world.
Understanding how the climate will change in the future and how it will impact regions across the world is not straightforward. Climate models (computer simulations of the Earth’s climate system which cover historical and future time periods) are one of the main tools to obtain climate projections. By inputting different scenarios for greenhouse gas emissions, it is possible to understand how the climate may respond to different concentrations of emissions. This allows assessments of how the impacts of climate change in a specific location might differ between a world where we limit warming to 1.5 °C above pre-industrial levels, and one with limited climate action (action based on current policies would lead to a warming of between 2.2 and 3.4 °C).
The pathway to limiting global warming to 1.5 °C, essential to limit the most catastrophic impacts of climate change, is becoming progressively more challenging. This makes the need for businesses to identify, assess and prepare for future climate conditions increasingly important and urgent.
Climate-related physical risks are caused by the intensity and/or frequency of extreme weather events as well as impact from climate patterns and are exacerbated by climate change. Climate-related physical risks are categorised into acute (event-driven risks such as floods, cyclones, heatwaves, and fires) and chronic (long-term shifts in climate conditions such as sustained increased temperatures, changes in rainfall patterns, and sea level rise). Physical risks can impact businesses either directly (e.g., through damage to buildings and equipment) or indirectly (through supply chain disruption).
The magnitude of physical risks in the future depends on two main components: the possibility of a climate event occurring at the relevant locations for the organisation (e.g., floods, heatwaves, droughts), referred to as exposure; and how prepared (or not) an organisation is to respond to this climate event (e.g., poorly maintained assets and equipment are likely to get damaged, staff not trained to prepare and respond to events, lack of flexibility and resilience in supply chain could lead to increased disruption), referred to as vulnerability. Two assets in the same geographical location (same exposure) might have very different risk levels because of how they have been constructed, prepared, or adapted to respond to climate events (different vulnerability).
The change and magnitude of physical risks depends on how greenhouse gas emissions evolve over time in the different climate scenarios. Hence, multiple plausible scenarios need to be considered to properly assess and prepare for physical risks. The assessment of risks in these different scenarios is referred to as a climate scenario analysis (CSA).
We know that the climate is already changing and that this change is accelerating. Even if emissions decreased drastically from today, we have already committed to a certain degree of change (in April 2024 global warming reached an estimated 1.28°C). Due to the impacts of climate change that we’ve already committed to, it is estimated that the world economy may experience an income reduction of 19% by 2050. A recent survey of UK businesses found that nearly half of the respondents are already impacted by climate change, with impacts being felt through increased operating costs, disruption to supply chain and direct physical damage to assets. In addition, close to fifteen per cent of businesses mentioned that they have been forced to change their business model.
Given the physical impacts we are already experiencing, the impacts we’ve already committed to, and the (not fast enough) pace of emissions reductions; preparing for physical risks is now an imperative when considering the potential financial losses for an organisation.
The need to understand and adapt to physical risks is increasingly being recognised and captured in regulatory requirements and climate disclosure frameworks. Already in 2017, the Task Force on Climate-related Financial Disclosures recommended carrying out a climate scenario analysis covering both physical and transition risks and identifying measures to reduce material risks. This same focus is kept in the new International Financial Reporting Standards S2 (IFRS S2), with more emphasis on the need to assess these risks quantitatively and in understanding financial implications. The EU Corporate Sustainability Reporting Directive (CSRD) includes the analysis of physical risks considering the 28 physical climate hazards included in the EU Taxonomy, adaptation is one of the six objectives in this taxonomy. In the UK, companies holding an environmental permit issued by the Environment Agency will now need to integrate climate change risk assessment and adaptation planning within their environment management system (required for environmental permits).
Exposure – Deriving insight from complex climate models and datasets.
When first considering physical risks, it is important to consider how the location of your assets and value chain might be exposed to a wide range of climate hazards. The EU taxonomy provides a comprehensive list of 28 potential climate hazards that an organisation might be exposed to, such as floods and heatwaves. Following an initial assessment, a deep-dive exposure analysis of selected priority physical risks for critical locations might be required to obtain more detailed estimates for the specific hazards that might cause damage and enable a robust estimate of financial impacts (see more of financial impacts below).
Climate model outputs combined with additional impact models (e.g., hydrological models able to provide robust estimates on flood extent and depth) are key to understand both historical and future exposure. Data outputs from climate models can be complex and large (due to the need to consider multiple scenarios, time horizons, locations, and hazards) and require expert knowledge to analyse. Inherent uncertainties and underlying assumptions need to be considered to support robust decision-making and avoid misinterpreting results.
Vulnerability – Understand your organisation’s level of preparedness.
To get a full understanding of risk from physical hazards you will need to assess the vulnerability of key assets and operations. To do this, data and information on the characteristics of company assets, operations, procedures and processes will be needed. To get the full picture on vulnerability, the information analysed should provide insight on:
The vulnerability of organisations and their value chain to climate hazards have not received as much attention as the analysis of exposure. In some cases, it is overlooked or just considered at a very high level (e.g., using generic industry data or based just on one of the components of vulnerability). It is important to assess all key components of vulnerability in order to get an understanding of where vulnerability arises from within the organisation and/or asset. This will then inform which actions you should take towards increasing resilience and avoid any potential maladaptation.
The financial impacts of physical risks
Financial impacts from physical risk can arise from direct impacts such as increased capital costs due to damage to buildings and equipment and/or indirect impacts such as reduced revenue from decreased production capacity due to disruption in the supply chain. A good understanding (quantitative where possible) of both exposure and vulnerability is needed to then estimate the potential financial impacts.
The evidence and research on how the occurrence of a specific event may translate into a financial cost has significantly increased and improved in recent years. For example, we now have a much better understanding on how heatwaves impact wellbeing and productivity of employees; or how flood events might cause business disruption due indirect effects (e.g., transport and energy system disruption leading to employees unable to access a site). As per any step in understanding climate risks, there will likely be assumptions and limitations in the estimate of financial impacts. Clear communication and transparency on both confidence and uncertainty levels is needed to inform decision-making and support next steps.
Most large organisations will have already started their journey on assessing physical risks. These organisations may leverage their early efforts to estimate financial impacts and begin preparing to reduce the most material impacts, adapting to climate change.
While mitigation focuses on preventing or reducing the emission of greenhouse gases, adaptation focuses on the steps needed to adjust to the effects of climate change (current and future). Within adaptation, there are a whole range of actions and measures which your organisation might consider for reducing physical risks. Identifying the most robust, cost effective and suitable set of measures within your context requires early planning.
A good starting point to reducing physical risks is the development of a climate adaptation plan. A climate adaptation plan should identify suitable measures to be implemented, the timeline for their implementation, maintenance, alignment with other activities and initiatives (e.g., refurbishments, supply chain flexibility and redundancies, decarbonisation actions), as well as the governance in place for risk management.
Adaptation does not only present cost saving opportunities for both current and future risks, it can also lead to additional benefits. A typical example of these co-benefits is the use of green infrastructure to manage flooding which might bring biodiversity and carbon reduction benefits.
The analysis of physical risks and development of adaptation plans cannot be done in isolation from other climate and resilience initiatives in the organisation. This is reflected in the guidance recently provided by the Transition Plan Taskforce (TPT). TPT recommends including adaptation and resilience in Transition Plans. A comprehensive transition plan can support the business in developing a robust climate journey which supports in meeting climate targets, while managing risks and enhancing resilience.
This factsheet looks at what climate-related risks and opportunities are and why organisations need to consider and assess them.
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