Climate Risk Management And Why It Matters to ESG

Climate change is one of the defining challenges of the 21st Century. The impacts of this phenomenon are devastating and far-reaching, affecting the environment and all aspects of humanity. Findings suggest that to mitigate climate change risks, one of the most effective tools is the use of climate risk management and ESG practices.

Recent studies have indicated that climate change has economic and financial implications that can significantly affect the investment landscape. Rising sea levels and extreme natural disasters caused by global warming can disrupt a firm’s production. Assets of companies that are heavily dependent on fossil fuels can be exposed to the risk of losing most of their value if households, governments, and firms make bold and rapid moves toward sustainable options. Climate change can also lead to new types of lawsuits as those responsible for these changes could be held accountable. These climate risks and why they matter in a company’s ESG profile are further discussed below.

What is Climate Risk?

Broadly, climate risk is the formal assessment of the consequences, likelihoods, and responses to the implications of climate change and how societal constraints shapes adaptation choices. In the financial space, climate risks to assets can be disaggregated into three: regulatory or transition risk, litigation risk, and physical risk. 

The transition risk encompasses climate policies and regulations that are presently being restructured to shift the global economy away from fossil fuels. Political initiatives that are introduced to reduce carbon emissions can make business models based on the exploitation of fossil fuels lose much of their economic value. If financial investors do not integrate this possibility, this can lead to a carbon burble – which basically means that fossil fuel-dependent companies may be overvalued.

This risk is far from theoretical: the Paris agreement, signed in 2016 by 195 countries, obligates these governments to limit the temperature increase to 1.5 above pre-industrial levels. In efforts to comply with some parts of this agreement, states are starting to execute environmentally friendly regulations that affect current corporate cash flows.

Secondly, firms face litigation risk. Companies that generate and emit more CO2 than others are more liable to class-action lawsuits and other legal attention, which will seek to make them responsible for climate change. As people pay to adapt to increased regulatory pressure or to mitigate the impacts of global warming—for instance, people living in coastal areas that are more affected by changes in sea level—the incentive to demand compensation from the groups responsible for climate change will surge.

At present, more than 1,000 climate-related lawsuits have been filed across the world. Kivalina v. ExxonMobil Corp., where people from a region in Alaska asked for compensation from major oil companies for extreme weather events that were seen as a consequence of climate change is a prime example. While these lawsuits have slim chances of succeeding today, they can lead to direct costs and reputational damages.

The business and economic impact of warmer temperatures, more frequent and severe weather events, and rising sea levels constitute the last type of climate risk—physical risk.

Investment firms should also be concerned with costs generated by the subsequent political instability and conflicts that climate change may instigate. Former UN Secretary-General Ban Ki-moon identified Sudan’s Darfur region as the first climate change conflict in the world, as alterations in rainfalls triggered water shortfall. Research also suggests that extreme or abnormal rainfalls and temperatures systematically and significantly increase the risk of conflict and violence.

Notice that the aforementioned risks are dependent on each other. For instance, if the transition to a sustainable economy is strong and quick, then the effects of global warming can be reduced, which would attenuate the direct negative impacts of climate change.

Climate Risk Management and ESG

Climate risk borders on the environmental portion of the ESG factors. The “E” examines how companies utilize natural resources and the effect of their operations on the environment, both in its direct operations and across their supply chains. In other words, the environmental element takes into account a company’s environmental disclosure, impact, and efforts to reduce carbon emissions — issues that represent tangible risks and opportunities for stakeholders and stockholders alike. 

Thus, firms that are environmentally responsible and less likely to suffer from the financial implications of climate risks. For instance, a company that increases its investment in new sources of energy or technology is adequately prepared for the transition away from fossil fuels.  Already, climate change is playing a crucial role in determining companies’ long-term creditworthiness due to potential losses in infrastructure and property.

Also, when evaluating companies’ ESG profiles many investors do not only weigh the potential social and governance risks to determine an entity’s capacity to operate successfully, but also the preparedness assessment of its capacity to anticipate and adapt to a variety of climatic disruptions.

Conclusion

Climate change has become an investment consideration impossible to ignore, as related disasters and economic losses rise and regulators increasingly recognize it as a systemic financial risk. Therefore, companies and investors must adopt strategies to manage the growing risk. Firms must ensure that they provide transparent environmental disclosure that clearly accounts for their climate risk mitigation measures while investors can help firms pollute less by directly influencing management decisions or purchasing green bonds.