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Why You Need to Understand Physical Risk and Transition Risk
Sustainability

Why You Need to Understand Physical Risk and Transition Risk

By | August 22, 2022

Risk has always been a fundamental aspect of business. But companies today are dealing with risks that are relatively new given the long history of commerce, and climate change is perhaps the most significant among them. Climate-related risk is also borne by investors, who have called for businesses to measure and report it.   

Investor demands are behind a slew of new climate-related disclosure regulations that require business leaders to measure and report that risk, so investors can make more informed decisions. In many cases, disclosures must include an assessment of physical risk and transition risk.     

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As Temperatures Rise, Risk Grows

To understand physical risk, simply look at weather-related headlines from the past year. Heat waves, floods and wildfires have been more frequent and more intense. And the losses associated with these weather events can be extensive, with financial costs that are often astronomical. This explains investor demands for accessible and transparent assessments on the physical risks that companies face.  

According to Resource Watch: “The physical risks from climate change stem from periodic event-driven natural disasters as well as chronic, long-term changes to climate patterns. Left unmanaged, these climate-related physical risks can lead to reduced resilience and significant financial losses.”  

When we think of physical risk, we typically think of the headline weather events that end up in our news feeds. But the other, equally harmful physical risks—”the long-term changes to climate patterns”—rarely make the evening news. In an earlier blog on double materiality, we referred to the example of rising sea levels and storm surge and their impact on U.S. energy facilities. While storm surge is linked to hurricanes and tropical storms that draw media attention, the slow pace of sea-level rise relegates it to scientific journals and smaller audiences. Consumers don’t think much about it, but businesses with operations in any coastal location cannot afford to ignore it.  

Check our recent blog on climate change and the global economy for more examples and insight into the impact of climate change on business.  

Climate Change Demands a Transition

As the Intergovernmental Panel on Climate Change (IPCC) and other bodies make clear, we—governments, consumers and businesses—must change. Governments must use policies, regulations and incentives to require, or at least promote, greater respect for the environment and better stewardship of its resources. We consumers must change how we shop, eat and travel, among other things. And businesses must change how they operate.  

Companies need to understand and adapt to the effects of climate change that we’re experiencing and are likely to experience in the coming years. They also have to assess how their operations contribute to global warming and climate change. Both assessments—which are encompassed in the concept of double materiality—are necessarily leading to a revision of existing business models and driving innovation. And it’s from these developments that transition risk emerges.   

The Bank of England explains how the required response to climate change causes transition risk.  

“Transition risks can occur when moving towards a less polluting, greener economy. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business. It’s not that policies stemming from deals like the Paris Climate Agreement are bad for our economy – in fact, the risk of delaying action altogether would be far worse. Rather, it’s about the speed of transition to a greener economy – and how this affects certain sectors and financial stability.”  

 

Transition risk is complex, and it can elicit a glass-half-full or glass-half-empty attitude and approach. Because, while the transition to a greener economy will produce threats, it can also yield opportunities. Consider companies that rely on single-use plastics: How are they adapting to the bans that countries are imposing on these plastics? Will they be able to identify and tap opportunities as they contend with these bans? If they can’t, other entrepreneurs and companies will, as the Indian company that designed cutlery made from dried and pressed palm leaves has.  

Whether a company can turn transition risks into opportunity or not, investors—and now regulators—want to know how companies intend to respond to them.  

Risk Management Now Includes Physical Risk and Transition Risk

Business leaders know that risk management looks different now. Take the companies based in the western U.S.: They may not have been planning for a gradual disappearance of the Lake Mead and Lake Powell reservoirs, but you can be sure they’re thinking about it now. Weather and climate-related events demonstrate the need for change in the most vivid way possible, and these physical risks are serving as the precursor to some of the transition risks that companies also face. The climate is changing, and businesses must now adapt. Investors and regulators want evidence of companies’ plans for adaptation.  

Enterprise Advanced Risk Assessment Software Is Within Reach
Enterprise Advanced Risk Assessment Software Is Within Reach
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