Climate risks: from environmental issue to financial priority

There has been a shift in the last 20 years in thinking about environmental issues as being a cost of doing business to something that defines how business develops and dictates the financial risks and opportunities presented to companies and their shareholders.

A major driver for this transformation were the recommendations from the Taskforce for Climate-related Financial Disclosures (TCFD) introduced in 2018. This requires financial institutions to evaluate both:

Physical risks – How climate impacts company operations and
transition risks – How a company’s actions impact the climate.

Risks from energy transition

For transition risks, TCFD requires consideration of policy, market, technology and reputational risks – each bringing its own uncertainties.

Policy is evolving in fits and starts. If “politics is the art of the possible”¹, then policy changes move when the mood of policy makers converges. At the moment, we are seeing a push back from economies heavily reliant on fossil fuels, which aim to slow the pace of change. This has led to significant disappointment among climate change advocates, particularly regarding the outcome of COP29², who argue that we are not moving fast enough as it is. Kudos to the EU for leading the way with benchmark legislation. But this has not been a simple task and shifts in the make-up of the European Parliament have delayed key decisions.
The market plays a dual role. More generally, it moves with the policy regime which provides a degree of certainty and direction. However, the financial industry has pushed the pace of change in many respects, as they work to move out of investments with end-of-life business models and look to new opportunities. Balancing portfolios to profitably meet ESG targets, particularly those for emissions reduction, is the focus of quite a lot of transaction activity. Investments need to meet the ESG sniff-test before they are considered from a financial perspective.
Technology is a critical tool for many companies aiming to reduce GHG emissions. While the broad perspective appears promising, the challenge lies in the details. Changing sources of electrical power is relatively straightforward, with green power purchase agreements providing a quick route to decarbonisation. In some cases, simply waiting for national grids to decarbonise may be a viable option. However, the need for heat is far more complex. Moving from gas to electric heat generation is typically costly, even with the use of heat pumps, which are not always compatible with existing heat networks. Hydrogen presents supply challenges, unless you are lucky in your location, and technology such as hydrogen-ready gas turbines are still unproven in long term trials. Hard to abate solutions might look to CCS for salvation, but it introduces additional energy demand, doesn’t remove all of the emitted carbon dioxide and needs somewhere to sequester the GHG. The uncertainty surrounding which technologies to adopt often hinges on local conditions- such as access to waste heat sources.
Reputational risks stem from the need to be perceived as doing the right thing, alongside potential pushback from stakeholders.. Companies often assess these risks based on legal jeopardy, which is measurable to some extent.

However, the potential for a reduction in the social license to operate is another possibility. This is where the ESG-driven concept of generating stakeholder value is important. It encourages CEOs to engage with a broader range of NGOs and community leaders, incorporating diverse perspectives into decision-making and demonstrating that a wider range of needs has been considered and addressed.

All of this underscores the need for investors, asset managers, and company executives to develop new skills and adopt a broader perspective. A few years ago, setting a vague decarbonisation target for some distant future was sufficient to satisfy investors and regulators. Today, such targets must be backed with a credible plan, measurable milestones, and a well-argued business case. This means hedging your bets is no longer a credible option, and truly “no-regrets” options may not exist.

These four aspects - policy, market, technology and reputation - are intertwined. Policymakers have the option to influence the market to speed up investment in new greener technology and set the societal agenda. This can be achieved through mechanisms such as carbon taxes, incentives, and clear communication campaigns. However, there is a limit to what can be done in isolation without massively reducing national competitiveness. This is where the EU has an edge: as a large and cohesive market, it has the capacity to push further and achieve more than individual countries can on their own.

So, a lot to consider, and in recent years, the focus has rightly been on transition risks for several reasons:

COP29 has shown that momentum for change still isn’t where it needs to be and cannot be taken for granted.
The energy transition and decarbonisation efforts are causing significant market disruption, eroding some long-standing business models while creating huge opportunities for new technologies and ways of doing business.
Regulation is increasingly driving change, altering market dynamics and compelling executives to face up to the strategic business decisions necessary for a sustainable future.

Climate risks to business

The evaluation of physical climate risks has often been seen as a tick-box exercise, largely because these impacts were perceived as distant concerns. However, this view is changing:

Storm Boris brought devastating impacts across Europe in September 2024, with Italy, Poland, the Czech Republic, Romania and Austria particularly hard-hit, leaving 21 people dead³. This event highlighted the vulnerability of national infrastructure to severe weather and the inadequacies of civil contingency planning.
North America has suffered a series of major storms in 2024, including high winds, flooding, tornadoes and heavy snowfall. The hurricane season set records, with hurricane Beryl reaching category 5 status earlier than any previous storm of that magnitude. Helene and Milton caused catastrophic flooding and storm surges.⁴
Asia faced an active typhoon season, with typhoon Yagi claiming 14 lives in Vietnam and causing extensive damage across China and the Philippines in September 2024 . In India, the monsoon season delivered 7.6% more rainfall than usual, according to the India Meteorological Department⁶.
Heatwaves reached unprecedented levels, with the planet recording its hottest day in 80 years on 21st July, only for that record to be broken on the following day, according to the Copernicus Climate Change Service⁷. Extreme heat events impacted the Americas, Africa, Europe and Asia, including a tragic incident in Mecca in June where over 1,000 people collapsed⁸. Temperatures of 50oC days are now twice as common as they were in the 1980s⁹.
Munich Re reported that in the past year natural disasters have caused USD 320 billion in damage worldwide, of which USD140 billion was insured. This is much higher than the average over the last 30 years.¹⁰

Changing perception?

The growing evidence suggests le that climate change may be unfolding faster than initially expected. Its effects are becoming increasingly apparent, disrupting company operations and supply chains, and sharpening the focus on resilience.

Physical climate risks present a dual challenge for companies: Extreme weather events directly affect infrastructure and operations, but also disrupts natural services that companies rely on for water, flood protection, shelter and pollination.

While monetizing transition risks is important, it’s equally vital to understand how physical risks impact operational costs and investment decisions. Unfortunately, many of these costs remain hidden until an event highlights them, making it difficult to assess the return on investment in resilience measures. To address this, we need a clearer understanding of the real costs of climate change for businesses.

This challenge is compounded by historically poor data on both physical climate risks and the natural environment. Data sets, often collated for different purposes, lack coherence and completeness, leading to uncertainties - particularly for forecasts extending beyond 2050.

Additionally, top-down screening of hazards is affected by the importance of local details in determining climate impacts. For example, exposure to flooding and high winds depends heavily on subtle variations in local topography.

Developing understanding

Climate science is continuously developing, offering new insights into complex phenomena. For example, the understanding of polar storms on northern hemisphere weather is still an active area of study, and the potential effect of tipping points- sudden shifts in climate systems such as the ocean conveyor belt - are gaining increasing attention. Enhanced processing power now allows researchers to examine the spikiness in climate model outputs, previously dismissed as artifacts and smoothed out, with greater precision.

The good news is that we are getting better at understanding the extent of uncertainty (i.e. knowing what we don’t know), This progress is enabling top-down assessments to better reflect details at local level, supported by ever-improving datasets. Over the next few years, these advancements could significantly reshape our understanding of climate change and the pace of transition required to achieve a low carbon economy.

This leaves the final challenge:

A key talking point when financial institutions meet climate scientist is “establishing a clear narrative”. Immersing oneself in the climate science helps to absorb and understand the complexities, but how do we communicate that to decision-makers? As one panel participant said at a recent CGFI¹¹ conference, “If I tell my executives about the size of the error bars on the figures I’m quoting they will laugh.”

From both a physical and transition risk perspective, determining that climate change is happening is clear. Yet, determining how to act, and how quickly, is still partly a leap of faith. The way to mitigate this risk is by leveraging the best available data and analysis, often going beyond high-level screenings to focus on specific assets and their operational environments. It’s then a case of monitoring the changing landscape and making course corrections along the way. The key take-away is clear: inaction is not an option. Decision-makers must embrace the challenge, informed by the best science and guided by adaptability, to navigate the uncertainties of a changing climate.

Join us to discuss how climate risks are shaping business strategy and investment decisions

📅 Join us in Amsterdam on 23 January 2025 for DNV’s Financing the Energy Transition event. Together with industry leaders, we’ll examine how these risks are reshaping financial systems and discuss practical steps for integrating them into strategic planning. Register here: Climate risk: from environmental issue to financial priority

Quote Otto von Bismark (1815 to 1898)
Five key takeaways from COP29 | BBC News
Storm Boris: Italy braces for rain as 21 killed in Europe floods | BBC News
https://www.yahoo.com/news/destructive-deadly-2024-atlantic-hurricane-111733897.html
Typhoon Yagi latest: Strongest storm to hit Asia this year kills 14 in Vietnam and injures hundreds | The Independent
2024 monsoon season ends with 7.6% more rainfall than normal: IMD | India News - The Indian Express
New record daily global average temperature reached in July 2024 | Copernicus
Extreme heat is breaking global records: Why this isn’t ‘just summer,’ and what climate change has to do with it
Climate change: World now sees twice as many days over 50C | BBC News
International insurer sounds the alarm after a year full of natural disasters
UK Centre for Greening Finance and Investment (CGFI)

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