Physical risk – how climate change affects business

Climate change is happening before our eyes. The following months are breaking records for average air temperature. We experience droughts, floods, typhoons, forest fires. Spain, Greece, the United States, Chile, Poland, Hawaii – there is virtually no place in the world that is not feeling the changes. So no one needs to be convinced that this is a significant risk to life, but also to our business. Climate-related risks can affect companies’ operations in various ways. It can affect directly, causing a tangible change in the space in which we function – we then speak of physical risk. It can also affect our company indirectly, such as through an increase in_CO2 emission fees as a result of implemented climate policies. Then we talk about the risk of transition.

Climate change is therefore one of those elements that should be taken into account when managing a company’s risks, but both business people’s awareness and the availability of information is limited. While in large multinational companies and financial institutions climate risk is gradually beginning to be assessed and analyzed for strategy definition, in the SME sector the topic is mostly new. Both transition and physical risks can very significantly affect the operation of a business. In this article, however, I will focus on physical risk – that tangible and visible side of climate change.

What is physical risk?

We define physical risk as caused by the occurrence of phenomena related to climatic factors, such as temperature, precipitation or wind. So we are talking about the threat to economic activity caused by physical phenomena. Depending on their nature, we can distinguish between sudden and long-term risks. To sudden risk we classify those phenomena that are violent in nature. We can indicate their beginning as well as their end. Thus, these are events such as flooding, drought, waterlogging, typhoons, hurricanes and heat waves. Climate change can either exacerbate or dampen the scale of the phenomena mentioned above. For example, heat waves in Poland are expected to last longer and longer due to climate change.

Long-term risks, on the other hand, are related to trends in climatic factors. Thus, these are permanent phenomena or low dynamics of change. Examples of this are water shortages, changes in the distribution of precipitation throughout the year, increases in average air temperature or changes in wind direction. The evolving climate is one of the key elements shaping long-term risk. Importantly, it may not be noticeable in the short term. This is because when comparing year to year, it is easy to overlook minor differences. We are then in the situation of the proverbial boiled frog. We start in cool water, the temperature of which gradually increases, but just slightly enough to escape us – until we are in boiling water.

Physical risks, both sudden and long-term, are very closely related to water. This is because the key issues for Poland are floods, droughts, flooding and shortages. Water circulation is thus a factor shaping the importance of physical risk. Of course, this is not the only element.

Impact of physical risk on companies

How physical risk affects a given enterprise depends on two things:

• The company’s exposure to a particular type of risk;
• The company’s vulnerability to these risks.

Exposure to physical risk, both sudden and long-term, is variable in space and time. The threat of drought or flooding is different in Greater Poland, different in the Mazury region, and different around Wroclaw. When assessing physical risk, therefore, it is necessary to study it in a given location. If the company has several different addresses, it is necessary to treat them separately, because the threat of climatic factors can differ significantly in them.

A company’s vulnerability is determined by the nature of its business and its dependence on natural resources. For a real estate management company, flood risk can be extremely significant, as damage to buildings from flooding will translate directly into their value. On the other hand, the flood risk for a wind farm company will be much less costly. For that, the impact of changing the distribution of air circulation will be key. Determining a company’s vulnerability should therefore be based primarily on mapping the dependence of a particular type of business on climatic factors. This is best done in financial terms. It’s worth it for both the here-and-now situation and the longer term, such as a decade.

The resultant assessment of vulnerability and exposure to a given physical risk should be a list of risks relevant to the business. After the assessment, we should be able to answer the question of how vulnerable we are to drought, for example, and what kind of losses we might incur if it occurs this year, and what kind of losses we might incur if the phenomenon occurs in 10 years. Actions planned for the future should be response-dependent, reducing the likelihood of occurrence (mitigating) and limiting the severity of its effects (adaptive). The costs of these measures are well weighed against the financial consequences of the materialization of risks to assess their effectiveness.

Financial sector and physical risk

As I mentioned at the beginning of the article, such analyses are already being conducted to some extent by large companies, including those in the financial sector. Indeed, climate risk is one of the key elements of ESG risk management. For banks, ESG risk management is one of the obligations imposed by a number of EU regulations. Many are required to disclose their exposures exposed to physical risk. Hence, one should not be surprised to hear the question when applying for a loan, among other things. o exposure to droughts and floods, as well as climate change mitigation and adaptation measures taken. Collaterals are also evaluated from this angle and their value is monitored. This is because physical risks involve very specific and measurable potential losses.