Anticipating risks and acting with confidence
Translating climate risks into quantifiable financial risk continues to be a challenge for companies around the world. Assessing climate risks within the value chain and a quantitative scenario analysis can be of help. This is part one of PwC’s Climate Transformation series, a sequence of five articles about both the impact of climate change on companies and the impact of companies on our changing climate.
Quantifying climate risk is key to strategy and compliance
Companies around the world are under increasing pressure to disclose a coherent climate risk analysis. For example, both the European Commission and the U.S. Securities and Exchange Commission (SEC) have proposed disclosure requirements for the projected financial impact of climate change on organizations using a climate scenario analysis.
Strategically, understanding climate risks is important for informing corporate strategy in the face of a changing climate, and setting the company on a more resilient growth path. Quantifying the financial exposure to risk can lead to enhanced trust from investors, lenders, and rating agencies. However, translating climate risks into robustly quantifiable financial risk continues to be a challenge for both real economy and financial institutions.
Scenario analysis: essential to climate risk assessments
A scenario analysis is effectively used in climate risk assessments as it provides useful insights into how an organization may be exposed to climate change over different future temperatures and varying time horizons.
For example, in a future scenario where global temperature rise is limited to 1.5 ⁰C, associated climate policies and actions are expected to increase the prevalence of transition risks arising from carbon pricing, climate litigation and technology development. Alternatively, if global temperatures continue to rise, this will lead to increasingly erratic weather patterns and more extreme weather events. In this scenario, understanding the impact of physical risks on the business at a local level will be critical so that key assets can be made more resilient to overcome the impact of climate change.
From physical risks to quantification
When looking at climate risks, current practice is to start with identifying areas where the exposure to transition and/or physical risks may have the most potential impact. For fossil fuel heavy companies this may include the implementation of carbon prices and for agricultural companies this may include crop growing regions that are vulnerable to specific extreme weather events. An in-depth qualitative analysis can then be performed to understand the dominant risks at hand.
From there, organizations can start to quantify the impact of these climate risks to better understand the potential financial implications. To perform both qualitative and quantitative analyses, organizations can use future scenarios from several reputable sources such as the International Energy Agency (IEA), the Network for Greening the Financial System (NGFS) and the Intergovernmental Panel on Climate Change (IPCC).
Three examples of commonly used climate scenarios
- International Energy Agency
- Network for Greening the Financial System
- Intergovernmental Panel on Climate Change
International Energy Agency
The International Energy Agency (IEA) uses the Global Energy and Climate (GEC) model to explore various scenarios built on a set of underlying assumptions about how different pathways for global energy demand and climate policy. The IEA has published three commonly referenced scenarios: the Net-Zero Emissions by 2050 scenario (NZE), announced pledges scenario (APS), and the Stated Policy Scenario (STEPS).
Network for Greening the Financial System
The Network for Greening the Financial System (NGFS) provides scenarios to help banks and other financial institutions explore the possible impact of climate change on the economy and the financial system. There are six different scenarios to assess transition and physical risks: Net Zero 2050, Below 2°C, Divergent Net Zero, Delayed Transition, Nationally Determined Contributions and Current policies.
Intergovernmental Panel on Climate Change
The Intergovernmental Panel on Climate Change (IPCC) has traditionally used representative concentration pathways (RCPs) scenarios for communicating climate impacts. The IPCC has also introduced Shared Socioeconomic Pathways (SSPs) which add a layer of socioeconomic factors (e.g., deforestation rates, food demand, energy demand, etc.) to help put the RCPs into a broader perspective.
Main challenges of climate risk quantification
Unfortunately, only a handful of companies have reported any quantitative details on the expected financial risks in differing climate scenarios. According to the status reports of the Task Force on Climate-related Financial Disclosures (TCFD) in recent years most organizations only disclosed financial impact of climate risks in a qualitative form, and even fewer reported quantitively on forward-looking physical risks.
Why is the progress towards quantitative reporting still stagnating despite disclosure requirements and strategic importance? Data needs, methodological considerations, and the lack of a structured framework could be some main challenges of climate risk quantification. To elaborate, the lack of available data may complicate and delay quantitative analysis.
For example, asset-level geospatial data is useful for determining exposure to future climate-related physical hazards but is often complicated to use. Moreover, the historical patterns between climate risks and financial consequences are not representative of future climate-financial relationships, limiting the ability for tools and models to be calibrated against historical data.
As a result, quantifying climate-related financial risks requires assumptions about the interaction between the climate, economic and social activities. As the number of companies that have performed a quantitative analysis is limited, there is still a lack of understanding in terms of knowing which variables, scenarios, and materiality criteria to use.
Quantifying the financial impact of climate risks: a case study
A global food and beverage company needed help to understand the potential financial impact of physical risks on the price of corn and coffee, as well as the impact of oil- and emission-related regulations on the price of plastic packaging.
The starting point is measuring physical risk, for which we use PwC's Geospatial Climate Intelligence tool. This tool helps predict the frequency and severity of climate hazards in the growing areas of the business in question. Using these predictions, we assess the effects on commodity prices using IPCC scenarios. We assess this using different scenarios: a high Representative Concentration Pathway scenario (4.3 ⁰C) and a low RCP scenario (2.0 ⁰C).
To quantify transition risks, we conducted research on the relationship between carbon prices and plastic prices using the International Energy Agency’s scenario NZE (Net-Zero Emissions by 2050 scenario) and STEPS (Stated Policy Scenario) to determine how plastic prices might behave in the future. The results were then combined to estimate the potential financial implications on key input materials and commodity prices per scenario, enabling the client to take this into strategic consideration.
PwC's Geospatial Climate Intelligence tool helps measure and predict physical climate risks.
From consideration to action: confidence is required
An effective sourcing strategy, a balanced research into alternative materials and fair cost passthrough implications – the possible considerations following a quantitative climate risk analyses are essential to corporate strategy and setting the company on a resilient and futureproof growth path.
The C-suite today needs new skills to future-proof the organisation. It can be exciting, confrontational and challenging to see the future outlined through climate scenarios knowing that taking next steps and making decisions based on these scenarios is desperately needed. This day of age shows that the necessary journey to sustainable progress requires self-confidence and leadership. In a time of great uncertainties, those leadership skills are rightfully a stable factor.
Series on climate transformation - Impacts, risks and opportunities
Climate change demands a lot from companies. The climate expert team within PwC distinguishes two pillars within climate transformation: the impact of the business on the world and the impact of the world on the business.
This series of five articles focuses on both pillars. This article on quantifying climate risks covers the impact of the world on the company. The continuation of this series focuses on the impact of companies on the route to net zero, the circular economy, biodiversity and nature. We conclude with a story on climate risk management, turning awareness into opportunity.
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