Have you performed your climate risk assessment?

When reporting climate-related financial disclosures under both IFRS S2 Climate-related Disclosures and the Task Force on Climate-related Financial Disclosures (TCFD), you must disclose information about climate-related risks that could have a financial impact on your business. Here, we explore the difference between the two types of climate-related risks you must consider in your risk assessment - physical and transition risks - as well as their potential financial impact.

Physical risk

The physical risk of climate change can be either acute or chronic:

• Acute (event-driven) risk arises from weather-related events such as storms, floods, drought or heatwaves, which are increasing in severity and frequency
• Chronic risks are due to longer-term shifts in climatic patterns, including changes in precipitation and temperature which could lead to sea levels rising, reduced water availability, biodiversity loss and changes in soil productivity.

The following is an extract from Table 1 contained in the 2017 Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures. It illustrates the potential financial effects of acute and chronic physical risks.

Type	Climate-Related Risks	Potential Financial Impacts
Physical Risks	Acute	Reduced revenue from decreased production capacity (e.g., transport difficulties, supply chain interruptions) Reduced revenue and higher costs from negative impacts on workforce (e.g., health, safety, absenteeism) Write-offs and early retirement of existing assets (e.g., damage to property and assets in “high-risk” locations) Increased operating costs (e.g., inadequate water supply for hydroelectric plants or to cool nuclear and fossil fuel plants) Increased capital costs (e.g., damage to facilities) Reduced revenues from lower sales/output Increased insurance premiums and potential for reduced availability of insurance on assets in “high-risk” locations
	Increased severity of extreme weather events such as cyclones and floods
	Chronic
	Change in precipitation patterns and extreme variability in weather patterns Rising mean temperatures Rising sea levels

An increase in the acute risk arising from more adverse weather events is likely to translate into negative financial impacts sooner than an increase in the chronic risk.

Transition risk

Transition risk arises from efforts to transition to a lower-carbon economy and include policy, legal, technological, market and reputational risks.

Policy and legal risk

Policy risk refers to governments’ evolving policies around climate change that may affect the financial viability of your entity’s business model. Policy risk may result in the government implementing policy action to either:

• Constrain actions that contribute to the adverse effects of climate change (such as implementing a carbon-pricing mechanism)
• Promote adaptations to climate change (such as shifting energy use to more green sources, adopting energy-efficient solutions, encouraging greater waste efficiency measures and promoting more sustainable land-use practices).

Legal risk arises from climate-related litigation claims brought by shareholders due to entities failing to take adequate steps to address climate change, as well as regulators. For example, we have seen the Australian Securities Investments Commission (ASIC) raise several green-washing actions against entities making false or inaccurate claims of climate credentials, or making insufficient disclosures regarding the risk of climate change.

The following is an extract from Table 1 contained in the 2017 Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures, and illustrates the potential financial effects of policy risk and legal risk.

Type	Climate-Related Risks	Potential Financial Impacts
Transition Risks	Policy and Legal	Increased operating costs (e.g., higher compliance costs, increased insurance premiums) Write-offs, asset impairment, and early retirement of existing assets due to policy changes Increased costs and/or reduced demand for products and services resulting from fines and judgments
	Increased pricing of GHG emissions Enhanced emissions-reporting obligations Mandates on and regulation of existing products and services Exposure to litigation

Technological risk

Technological risk is the threat of technological improvements or innovations enabling the transition to a lower carbon economy disrupting your business model and affecting the competitiveness of your products (think video machines and Kodak cameras).

Table 1, contained in the 2017 Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures, also illustrates the potential financial effects of technological risks (reproduced below). If you don’t successfully take steps to mitigate technological risk, your business could face lower profitability if you experience reduced demand for your high-emission products, and you may be forced to retire your existing assets early. Increased investment may also be required for research and development in new energy-efficient technologies.

Type	Climate-Related Risks	Potential Financial Impacts
Transition Risks	Technology	Write-offs and early retirement of existing assets Reduced demand for products and services Research and development (R&D) expenditures in new and alternative technologies Capital investments in technology development Costs to adopt/deploy new practices and processes
	Substitution of existing products and services with lower emissions options Unsuccessful investment in new technologies Costs to transition to lower emissions technology

Market risk

Market risk is concerned with the demand for certain commodities, products and services changing as a result of transitioning to a lower carbon economy. An example of this is more consumers turning vegan and eating less meat. The extract from Table 1 in the 2017 Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures summarises the potential financial effects of market risk.

Type	Climate-Related Risks	Potential Financial Impacts
Transition Risks	Market	Reduced demand for goods and services due to shift in consumer preferences Increased production costs due to changing input prices (e.g., energy, water) and output requirements (e.g., waste treatment) Abrupt and unexpected shifts in energy costs Change in revenue mix and sources, resulting in decreased revenues Re-pricing of assets (e.g., fossil fuel reserves, land valuations, securities valuations)
	Changing customer behaviour Uncertainty in market signals Increased cost of raw materials

Reputational risk

Lastly, reputational risk arises when consumer and community perceptions of your organisation change depending on how much you contribute or detract from the transition to a lower carbon economy. The extract from Table 1 in the 2017 Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures summarises the potential financial effects of reputational risk.

Type	Climate-Related Risks	Potential Financial Impacts
Transition Risks	Reputation	Reduced revenue from decreased demand for goods/services Reduced revenue from decreased production capacity (e.g., delayed planning approvals, supply chain interruptions) Reduced revenue from negative impacts on workforce management and planning (e.g., employee attraction and retention) Reduction in capital availability
	Shifts in consumer preferences Stigmatization of sector Increased stakeholder concern or negative stakeholder feedback

Conclusion

Climate change will likely impact all businesses, but will affect some industries, sectors and geographic locations more than others. For example, big mining companies face higher transition risk than professional services businesses as we move to a net zero economy. A manufacturing business with its primary warehouse near a flood zone will face higher physical risks than an IT services business, where employees can pivot to working from home during an acute climate event such as fires or floods.

How BDO can help

Knowing your risks is critical. Assessing your climate-related physical and transition risks to assess the financial impact and for climate-related disclosures is more than just a qualitative assessment. It requires a detailed evaluation of all risks, including quantitative modelling, and our national team of sustainability experts can help. Contact us today.