ESG report -Risks

Transition risks

To halve CO2 emissions by 2030 and to reach net zero by 2050, a rapid and systemic transition is required, impacting all sectors and industrial systems (IPCC, 2018). Such a complex and comprehensive transition will affect demand for resources, products, services, jobs and financial capital. It will also inevitably involve a broad range of associated risks for businesses, the financial sector and the real economy (Krishnan et al, 2022).

While some sectors may find that the cost of doing business increases, others may discover new opportunities. Nevertheless, all businesses are likely to find that the value of their assets is changing in various ways. This is especially true for sectors that are dependent on carbon-intensive resources and activities, such as the energy and transport sectors. In some cases, the entire existence of some of these sectors (as they currently operate) is threatened by the transition to net zero (Bank of England, n.d.).

Businesses are likely to be impacted by transition risks arising from four particular areas: policy and regulation, technology, markets and reputation. Table 1 outlines some examples for each one of these areas.

Table 1: Transition risks. (Adapted from: TCFD, 2017)

Climate-
related risk
Examples
Policy and regulationincreased carbon pricing rule changes for reporting emissions increased regulation of products and services.
Technologynew technologies that replace or disrupt old systems cost of investing in new, uncertain technologies stranded and redundant assets.
Marketsheightened cost of energy and raw materials shifting customer viewpoint and behaviour unpredictability in market signals.
Reputationshifting consumer perceptions increased stakeholder concern and negative feedback stigmatisation of sector.

The business impacts of these transition risks depend largely on the speed at which measures to mitigate climate change or improve resilience happens. If global climate action results in an immediate and steady reduction in GHG emissions, governments and businesses could be better placed to manage risks, disruptions and costs throughout the transition. If, on the other hand, climate action is significantly delayed, more radical and disruptive shifts would be required in order to reduce emissions more abruptly, resulting in higher adaptation and mitigation costs, more sweeping regulatory changes and more volatile market conditions (Krishnan et al., 2022).

Additionally, changing perceptions of these risks may prompt changes in consumer behaviour and social norms, with implications for businesses in terms of meeting fluctuating customer demands, filling potential employee skills gaps and managing increasing reputational and litigation risks.

Pause and reflect:

In its 2021 TCFD report, the professional services company PwC UK identified four specific transition risks. One of these was reputational risk: how the company’s response to climate change might affect its ability to attract and retain talent. This type of risk is a critical aspect of PwC’s operations. To read the report, search for “PwC UK Climate change risks and opportunities” online, and then reflect on the following question:

  • Which type of transition risk is the most critical in your professional context, and what could the potential business impact of this be?

Litigation risks

Organisations, corporations and governments are increasingly at risk of potential legal actions if they fail to take steps to mitigate climate change or if they take actions that undermine the safety and livelihoods of their workers and citizens (Hamaker-Taylor, Bater & Coudel, 2019). When people or businesses pursue compensation for financial losses caused by physical or transition risks, these litigation risks arise (Bank of England, n.d.).

Climate-related litigation risks include the threat of public nuisance claims, fraud or lack of disclosure. For example, a company with high GHG emissions may be sued because its operations pollute local regions – endangering the health of local communities; or on the basis that the company has knowingly concealed the climate-related risks associated with its operations. These types of liability claims against fossil fuel companies are becoming increasingly common, with plaintiffs alleging that the companies have acted deceptively and fraudulently (Setzer & Byrnes, 2020).

The following two key databases track and report worldwide climate-related litigation cases filed against companies and governments:

  1. the Climate Change Laws of the World database, which includes climate cases from over 30 countries, but excludes the US
  2. the US Climate Change Litigation database, which includes litigations and administrative proceedings related to federal, constitutional and state law.

At the beginning of 2022, over 1,900 climate-related litigation cases had been reported to these two databases, with almost 1,400 of the cases based in the US. The threat of litigation poses a real financial and reputational risk to businesses and their insurers, which needs to be weighed against the risk of continuing with business as usual.

Examples:

In the world’s first climate-related litigation case, hundreds of Dutch citizens and the Urgenda Foundation filed a lawsuit against the Dutch government for exposing its citizens to danger by failing to reduce GHG emissions. In 2019, the Dutch Supreme Court ruled that the government had a binding legal obligation to prevent climate change in line with international and national agreements, and commanded that the Dutch government lowered its GHG emissions by at least 25% (from the 1990 levels) by 2020 (Urgenda, n.d.).

In a high-profile case in 2021, the oil and gas company Shell was ordered by a civil court to “cut its absolute carbon emissions by 45% by 2030, compared to 2019 levels” (Bousso & Nasralla, 2021). This was a historic ruling; for the first time, a company was held legally responsible for aligning its corporate policy with the Paris Agreement, and for reducing both its own emissions and those of its suppliers and customers. The global implications of this are thought to be seminal and far-reaching.

Systemic risks

The climate-related risk landscape is complex and dynamic. As our environmental, social and economic systems are highly interconnected and interdependent, risk assessments need to consider the systemic nature of the risk associated with climate change and the transition to net zero:

Systemic risks arise from the consequence of direct impacts – materializing as a chain, or cascade, of impacts – compounding to produce even more severe impacts for people and societies.

(Quiggin et al, 2021)

Cascading effects are a key feature of systemic risks. They can be seen when an event generates a series of indirect effects that then spread further and trigger major changes in environmental, economic, geopolitical, social or technological systems. These indirect effects can also be amplified by feedback loops that are often poorly understood. At their worst, systemic risks can lead to a total system collapse.

An example of systemic risk:

In 2008, 20 provinces in South China experienced heavy rain, snow and sleet for several consecutive weeks, generating severe direct and indirect impacts on all major sectors of the economy. The direct consequences led to severe disruption of electricity and water supplies, damaged railways, airport closures, reduction of agricultural outputs, destruction of property and negative impacts on the forest ecosystem.

These effects cascaded through to the wider economic and social sectors, leading to a series of indirect effects. Energy shortages lead to many industries being shut down. As the event occurred during the Spring Festival, tourism fell dramatically; public security was impacted as millions of tourists were stranded at stations and airports. Property damage and power cuts resulted in frozen and damaged water pipes, leaving residents without drinking water. The income of the local population fell due to decreased industrial and tourist activity. The damage to the forest increased the amount of dead trees, which in turn increased the rate of forest fires, diseases and pests (Li et al., 2021).

The interconnected landscape of systemic risk is powerfully illustrated in the Global Risks Interconnections Map 2020 from the World Economic Forum (WEF). The interactive map is based on an annual survey of risk perception amongst business leaders, policymakers and non-governmental actors. Figure 1 provides a simpler version of the interconnected nature of climate-related risks.

This figure illustrates how the five main global risks (environmental, geopolitical, economic, technological and societal), represented by icons in the centre of the figure, are interconnected. Climate action failure (environmental risk), for example, can result in natural disasters and extreme weather (also environmental) and water and food crises (societal risk). In turn, each of these risks can result in the occurrence of other, interconnected and related risks.

Figure 1: The interconnections between global risks.
(Adapted from: WEF, 2020)

Understanding the potential commercial and social implications of systemic risks can be challenging for governments, businesses and investors alike. However, with an increasingly unpredictable climate and an accelerating transition to a net zero economy, the likelihood of systemic risks impacting entire sectors as well as individual businesses is growing. Stakeholders such as investors, lenders and insurers are increasingly required to understand how prepared businesses are to address these risks.

Explore further:

The WWF releases an annual report highlighting global risks in terms of likelihood and impact. The shift towards environmental risks has increased significantly over the past decade and in 2022, five of the top ten risks were environmental.

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