Managing the Potential Financial Impacts of Climate Change

As new temperature records are set and climate risks mount, climate change will continue to impact sectors across the economy.

The impacts of climate change will materialize differently in different sectors. In some, such as agriculture, the effects will be direct, such as floods, wildfires, changing weather patterns. There will also be indirect impacts, such as higher commodity prices cascading through their supply chains.

In areas such as the financial sector, impacts may have second- or third-order effects, such as higher borrowing costs, increased market volatility that transmit through firms, supply chains and feedback through the wider economy.

As physical climate risks accelerate, firms will face new financial challenges.

Physical risks directly impact firm-level assets, causing damage and business interruption.

As physical risks mount, firms may experience negative impacts on financial performance, including higher operating expenditure (repairs, maintenance, insurance), higher manufacturing costs (supply chain interruptions), higher capital expenditure (replacing lost or damaged assets), declining book value of assets (vulnerable or stranded assets) and revenue losses (business interruption).

The availability and cost of insurance will become increasingly important.  In states such as California, Texas and Florida, insurance companies have taken steps to manage their exposure to climate-related perils such as wildfires, sea level rise and floods.  

Longer-term shifts in climate patterns, such as higher temperatures, will affect firm and sector productivity over time.

Risks arising from the transition to a low-carbon economy, such as technological changes or shifts in consumer preferences, can affect firms at the corporate or strategic level. These risks can also be driven by regulatory changes, such as the introduction of a carbon price or new energy standard.

If firms do not address transition risks, they may face strategic or product obsolescence and/or asset stranding assets, with potential implications for their market position or potentially even their long-term viability as policy, technology advancement and consumer expectations change.

A firm that understands its climate risks is better equipped to mitigate the financial impacts.

Firms should consider how climate risks will affect costs and revenues by understanding the transmission mechanisms of risks into key financial items, including both direct and indirect channels.

By analyzing how climate risks affect functions and assets, and how climate risks exacerbate existing business risks, firms can improve their climate resilience.

Among the keys to such an assessment are variables that can provide insight into climate exposure and vulnerability:

• Business type, sector and subsector
• Profit drivers, market dynamics and customer base
• Key assets (physical, financial and intangible)
• Financial projections and underlying assumptions
• Interdependencies of the firm and its key supply chains
• Critical infrastructure (road networks, water supply, electrical grid)
• Regulatory environment(s) affecting how the firm conducts its business

Even as firms may be at the initial stages of understanding their climate risks, the financial impact of their decisions can lead to knock-on effects in the economy and financial system.

For firms and investors, climate risks will drive and exacerbate business risks, including operational, strategic, compliance, reputational and financial risks.

For investors, climate impacts on financial assets will be second order effects on credit and business risks for borrowers and investee companies respectively, aggregated at the portfolio level. Impacts on firms, financial assets and portfolios may transmit climate risks into the wider financial system and economy.

Disclosure requirements, such as those in force in the European Union and proposed in the U.S., are intended give investors more “consistent, comparable, and reliable information” about how climate-related risks might impact their portfolios.

This regulatory push and demand from investors will require that companies assess the potential financial implications of climate change on their operations and financials.

WSP advises clients on their exposure and vulnerability to climate-related risks and opportunities, including the potential financial impact of climate change on their assets, supply chains and customers.

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