Published: 6 May 2024
Contributor: Amanda McGrath, Alexandra Jonker
Climate risk refers to the potential negative effects of climate change on various aspects of the environment, businesses and society.
Rising global temperatures, attributed to increased greenhouse gas emissions from human activity, might result in changes in the global climate system. This, in turn, impacts the Earth’s weather and natural ecosystems, and the ways in which human beings live and work. As the world works to better understand the impacts of climate change, experts and policymakers are taking steps to understand and measure climate risk—and find ways to mitigate it.
Understanding climate risk is important for many reasons. The consequences of climate change can exacerbate social inequalities and harm public health. The World Health Organization estimates that between 2030 and 2050, climate change might cause approximately 250,000 additional deaths per year from malnutrition, disease and heat stress.1 In addition, extreme weather events can lead to loss of life, displacement of people and increased poverty.
According to the Task Force on Climate-related Financial Disclosures (TCFD), these changing climate conditions also have potential financial implications for organizations and the global financial system at large. Such implications include property and infrastructure damage, operational disruptions and increased insurance claims. Investors are increasingly considering climate risk in their investment decisions. Meanwhile, governments and other entities worldwide are developing new regulations and standards that require businesses to assess and disclose their climate-related risks.
Most often, climate risk impacts vulnerable populations, such as those in low-income countries or areas with less infrastructure. Island nations and coastal regions face significant risks from sea-level rise and the increased frequency and intensity of tropical storms. In Sub-Saharan Africa, climate variability and changes in rainfall patterns can severely impact food security and water availability. In South Asia, countries including India, Bangladesh and Pakistan are at risk of consequences from extreme heat and changes in monsoon patterns. The region’s high population density may increase the potential impact of such events. And the Arctic is warming at a rate almost twice the global average, leading to melting ice caps and permafrost. This threatens its ecosystems and Indigenous communities and also contributes to global sea-level rise.
Climate risk can be broadly considered in three categories:
These are the direct threats that are posed by changing climate conditions. They include acute risks from extreme weather events such as hurricanes, floods, heatwaves and droughts. They also include problems that stem from long-term shifts in climate patterns, such as rising sea levels and increasing temperatures.
These risks arise from the process of adjusting to a low-carbon economy. As industries, businesses and communities make the transition away from fossil fuels, those that rely heavily on these resources may face significant financial losses and socio-economic disruption. This includes policy and regulatory changes, technological advancements and shifts in consumer preferences that might lead to reduced demand for certain products or services.
These risks are associated with people and businesses that suffered losses due to climate change and are seeking compensation from those they hold responsible. This might involve legal action against companies or governments that failed to mitigate their contributions to climate change or adapt to its impacts.
The physical, transition and liability risks that make up overall climate risk can have a variety of impacts. Here, a closer look at how they may affect businesses, communities and the environment:
Climate change is linked to an increase in the frequency and intensity of extreme weather events such as heatwaves, droughts, floods and storms. These events can damage infrastructure, disrupt operations and supply chains and lead to loss of life. Rising sea levels lead to land loss and displacement. And changes in precipitation patterns can lead to water scarcity in some areas and flooding in others. This can impact agriculture, affect water supplies and increase the risk of wildfires in dry regions. These changes also have a significant impact on ecosystems, leading to shifts in species distribution and threatening biodiversity. Coral reefs, for example, are highly sensitive to water temperature and are severely affected by ocean warming and acidification.
Climate change has profound societal implications, affecting various aspects of human life, from health and living standards to culture and social structures. It may exacerbate medical issues, from heat-related illnesses to driving the spread of diseases like malaria and dengue. Changes in weather patterns can complicate access to clean, safe water—which is essential for human health, agriculture and energy production.
Climate risk often disproportionately affects the most vulnerable populations, including those in low-income countries, indigenous communities, the elderly and children. This can exacerbate existing social inequalities and lead to increased poverty and marginalization, as well as displacement, instability and conflict. According to the World Bank, without climate action, more than 100 million additional people might be living in poverty by 2030.2
For businesses, climate risk can manifest in various ways. Physical risks from extreme weather events and changing weather patterns can damage assets, including buildings, equipment and infrastructure. They may also disrupt supply chains and production processes, and make it more difficult to find labor and maintain safe working conditions.
Climate risk can lead to higher expenditures for businesses, including increased insurance premiums or high compliance costs to meet new regulatory standards. Financially, transition risks may result in stranded assets, meaning they lose value or turn into liabilities before the end of their useful life. Companies and regions that rely heavily on fossil fuels, for example, may face significant financial risks as the world moves toward renewable energy sources.
At a macroeconomic level, climate risks can pose systemic threats to financial stability. For instance, a sudden revaluation of assets due to climate risks might trigger a broader financial crisis. And as stakeholders become more sensitive to climate risk, taking steps to assess and mitigate it may become an essential part of a business’ decision-making approach.
Assessing climate risk involves identifying and quantifying the potential impacts of climate change on an organization or a region. This includes finding likely physical climate hazards, such as extreme weather events and changing climate patterns, as well as transition risks associated with shifting to a low-carbon economy. Organizations must assess their susceptibility to these hazards based on a variety of factors and measure their likely impacts in the future. For example, a company might evaluate how many of its facilities are located in flood-prone areas. To quantify those impacts, organizations must estimate the damage in financial terms. This might involve calculating potential repair costs from physical damage, lost revenue from operational disruptions or compliance costs from new regulations.
Scenario analysis is also integral to climate risk assessment. It uses climate science to project future climate scenarios and their potential impacts. The data used in climate risk assessments can come from a number of sources. These include climate models, historical climate data, socio-economic projections and company-specific metrics. The methodologies used can vary widely depending on the scope of the assessment and the specific needs of the organization.
As more countries and organizations seek to set effective environmental, social and governance (ESG) goals, climate risk assessments can serve as a guide. For instance, the European Environment Agency published the first European Climate Risk Assessment (EUCRA) in 2024 to help identify policy priorities for climate change adaptation and to aid ESG decision-making.3
Building climate resilience requires a holistic approach that includes both mitigation (such as the reduction of greenhouse gas emissions) as well as climate change adaptation—that is, making sustainability changes so that regions and organizations can continue to function in the long term.
Shifting from fossil fuels to renewable energy sources such as wind, solar, geothermal and hydroelectric power can significantly reduce greenhouse gas emissions and, in turn, slow the overall rate of global warming.
Protecting and restoring forests, promoting sustainable agriculture and preserving wetlands can sequester carbon, protect biodiversity and buffer against extreme weather events.
Reducing the overall need for energy and implementing infrastructure that is more climate resilient can help reduce the environmental impact of producing and supplying power. This might involve constructing “green” buildings that incorporate features like efficient insulation and natural lighting or developing flood-resistant urban drainage systems.
Some financial instruments can help offset potential climate change risks and mobilize resources for climate action. Green bonds, for example, are issued to finance projects that have environmental benefits, such as renewable energy projects, energy-efficient buildings, or public transportation systems. And climate insurance can protect businesses and communities from the financial impacts of extreme weather events.
Governments and policymakers can implement a range of measures to help in building resilience. For example, carbon pricing involves putting a price on GHG emissions, either through a carbon tax or a cap-and-trade system, to provide an incentive for businesses to take reduction measures. Other measures may encourage investment in or transition to renewable energy, offset the cost of energy efficiency upgrades and set rules for sustainable development and fund new research and development. Many governments and organizations are increasing climate disclosure requirements to help investors, customers and other stakeholders make informed decisions.
Working together with other businesses, governments, NGOs, research institutions and other decision-makers can help countries and companies share knowledge, shape policy and develop innovative solutions to manage climate risk. Raising awareness and promoting climate education can empower individuals and communities to act.
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Renewable energy is energy generated from natural sources that are replenished faster than they are used.
Decarbonization is a method of climate change mitigation that reduces greenhouse gas (GHG) emissions.
Climate change refers to global warming, the documented global temperature increase of the Earth’s surface since the late 1800s.
Sustainability in business refers to a company's strategy and actions to eliminate the adverse environmental and social impacts caused by business operations.
ESG reporting frameworks are used for the disclosure of data covering opportunities and risks related to the environmental, social and governance (ESG) aspects of the business.
From climate change to overpopulation to biodiversity, environmental issues are complex and interconnected challenges facing Earth and its natural systems.
Footnotes
1 Climate change (Link resides outside ibm.com), World Health Organization, October 2023
2 Revised Estimates of the Impact of Climate Change on Extreme Poverty by 2030 (Link resides outside ibm.com), World Bank Group, September 2020
3 Europe is not prepared for rapidly growing climate risks (Link resides outside ibm.com), European Environment Agency, March 2024