Climate risk and vulnerability assessment

The objective of such an assessment is to evaluate the physical climate risk and to identify appropriate adaptation solutions that can reduce physical climate risks material to economic activity.

Introduction

Climate momentum is growing worldwide, and this is no surprise. More and more governments and companies alike are looking to integrate climate risk and opportunities into their long-term strategy and financial disclosures. Climate risk reporting is slowly becoming an expectation and, in some cases, we are seeing these disclosures becoming mandatory. Institutional investors put increased pressure on companies to disclose and measure climate-related risks, while governments in many parts of the world are committed to achieving net zero in the future. For example, China, one of the world’s largest emitters, pledged to achieve peak emissions by 2030 and carbon neutrality by 2060. The United Kingdom’s green finance strategy requires companies to disclose alignment to the Task Force on Climate-Related Disclosures (TCFD) by 2025, while in the European Union, we commit to achieving net zero emissions by 2050, as part of the EU’s ambition of becoming the first climate-neutral continent. It is therefore time for companies to start thinking about how the physical impacts of climate change will affect business models and financial performance because, in the end, climate risk is directly associated with financial risk.

Types of frameworks for climate risk assessment, an international context

The good news is that there are many sources of support for companies embarking on a net-zero journey. The bad news is that there are too many of them, and the companies find it hard to identify the methodologies most suitable for their specific processes.

Around the world, governments and financial institutions use various frameworks for disclosing and assessing climate risks related to their assets, be it physical or transition risks (risks related to the world moving to a low-carbon economy).

One of the frameworks for disclosing climate risks and opportunities was published by the Task Force on Climate-Related Disclosures (TCFD). It is mainly used for the protection of investors and its objective is to demonstrate the business strategy around climate. TCFD is a guidance framework based, as it does not provide specific requirements or metrics for physical risks, leaving it up to companies to determine what is material for their business operations.

Green Taxonomies (including the one currently in force across the EU) represent another kind of framework used for disclosing climate risk. They provide systems of definitions and classifications that would allow investors and any other stakeholder to understand what percentage of the company’s economic activity could be considered environmentally sustainable.

The Corporate Sustainability Reporting Directive (CSRD), published on 5 January 2023, requires companies in scope to disclose information on what they see as impacts, risks, and opportunities arising from environmental and social issues.

The Climate Reporting Standard (ESRS- E1) requires the disclosure of a considerable amount of information related to:

• the company’s impact on climate change;
• the impact that climate may have on the company’s financial matters.

It is also needed to provide a description of processes used to identify and assess material climate-related impacts, risks and opportunities, and potential financial effects from material physical risks.

Other frameworks used internationally for climate risk assessments are the so-called stress tests, used by financial institutions to define scenarios, timeframes, hazards, and economic conditions for the assessment of physical risks, thus allowing banks to analyse their vulnerability to climate risk.

So, what do all these types of climate risk disclosures have in common?

The assessment of physical climate risks under different climate scenarios and timeframes. In other words, if your company is trying to align with the EU taxonomy and at the same time you have to deliver a TCFD report for a different jurisdiction, it is not a huge leap since you have already met all the criteria for the EU taxonomy requirements. Conversely, if you already have a TCFD report where a physical risk assessment was performed, it represents a good starting point when performing EU taxonomy reporting/ alignment assessment.

EU Taxonomy and its requirement for a climate risk assessment

The EU Green Taxonomy is part of the EU’s sustainable climate package aiming to boost the flow of investments toward sustainable activities. For taxonomy-aligned activities, companies should receive easier access to capital markets.

Where in the EU Taxonomy is a climate risk assessment requested

Let’s explore where the physical climate risk assessment comes into play during the EU taxonomy alignment and screening process.

To qualify as a sustainable operation/investment, companies must show that their activities are:

• contributing substantially to one of the EU’s six environmental objectives[1];
• do no significant harm (DNSH) to the other environmental objectives. Climate risk and vulnerability assessment is a requirement that all economic activities must meet to achieve taxonomy alignment.

Depending on the environmental objective, companies may have to perform the climate risk assessment as part of the technical screening criteria (for the objective of climate change adaptation - Annex 2) or as part of the DNSH analysis (for the rest of the objectives).

Risk types

Climate risks are complex and can be classified as direct or indirect/cascading. Many impacts of climate hazards are obvious (for example damage to buildings from flooding). Other hazards occur in cascades or reinforce each other (for example, storms can damage electricity infrastructure, and when insufficient power supply, the production process can stop). Other risks arise only through the combination of more climate hazards (for example, the combination of storm and drought can lead to an increased risk of falling trees).

Levels of assessment

There are different levels of assessing climate-related risks, ranging from high-level, qualitative screening to detailed, quantitative, or geospatial assessment.

To decide on the appropriate level, one must consider the purpose of the assessment, the quality and amount of data or information available, together with the scale and nature of the risk.

A high-level, qualitative assessment could be a first step if limited data are available or as a method to cope with rapidly changing climate science, impacts, and understanding of climate risk.

This may identify a potential high risk, which could then be the focus of a data-collection phase to inform a later, detailed, quantitative, or geospatial risk assessment. It is important to note that when working with clients, our recommendations are in line with the sixth assessment report of the Intergovernmental Panel on Climate Change (IPCC AR6) and the international standard EN ISO 14091 (“Adaptation to climate change - Guidelines on vulnerability, impacts and risk assessment”), both state-of-the-art frameworks for climate risk assessments worldwide. We also follow the guiding principles of the German Environmental Agency on “how to perform a robust climate risk and vulnerability assessment for EU taxonomy reporting”.

Furthermore, during a quantitative assessment, we collaborate with best-in-class climate data providers.

Steps for physical climate risk analysis

The most important physical climate risks have to be identified using a robust and proportionate climate risk and vulnerability assessment.

To perform a climate risk assessment we need to follow several steps, which are part of two distinct phases: preparation and implementation phases.

1. Preparation phase:

a. First, as part of the preparation phase, we determine the expected lifespan for the taxonomy compliant economic activity and, at the same time, we identify the objects of assessment (the assets that are at concrete risk from climate-related hazards).

Knowing the expected lifespan of activities is crucial in climate risk assessment in order to tailor the analysis appropriately: short-term activities (with a lifespan of less than 10 years) rely on past climate trends and forecasts, while long-term activities require future climate projections. Unless there is a solid reason to expect an activity to stop within ten years, it is reasonable to assume that any economic activity will continue indefinitely. If a company plans to discontinue production of an eligible product, it is advisable to document the reason for the short lifespan. For activities with a lifespan of more than 10 years, a range of climate projections based on future scenarios and different timeframes will be considered.

In the case of a manufacturing business, the objects of assessment are the production sites, which are then divided into elements at risk decisive for their functionality, which can be, but are not limited to: infrastructure, people, maintaining storage conditions of raw materials, products and waste, integrity of equipment, availability and quality of supplies, transport networks, water or electricity. In practice, within a company, the assessment of risk varies across different infrastructures, flows, and relationships with suppliers and clients. It is critical to evaluate the risk based on the perceived value of these elements, requiring an assessment of their sensitivity. The materiality of the physical climate risk will be assessed for each element at risk.

b. The second step is related to the identification of climate-related hazards relevant to your activity.

The EU Green Taxonomy contains an extensive catalogue of climate-related “hazards that are to be taken into account as a minimum”.

It requires an assessment for 28 acute and chronic risk metrics across 4 categories: temperature, wind, water, and solid mass, divided into acute climate-related (extreme) events and “chronic” climate trends that change over time (e.g. slow-onset events).

A good starting point for analysing current climate-related hazards is looking at past changes and events. In case a specific extreme weather occurrence has increasingly disrupted operations in recent years and there is an expectation that climate change will lead to a higher frequency and/or greater intensity of such events, it is likely that such disruptions will occur more frequently in the next decade, provided no mitigating actions are undertaken.

• In accordance with the Climate Delegated Act, it is necessary to make an effort to access external sources of information in order to comprehensively assess all available data. Information on climate parameters and future scenarios is derived from regional and national meteorological services.

So how do we even begin to work through all of this?

We encourage our clients to focus on the hazards that are relevant to their business. For example, an agricultural company will be much more impacted directly by a draught than a consulting firm.

Therefore, at this stage, we will filter out climate-related hazards based on:

• Spatial occurrence (for example, in Romania we don’t have to worry about permafrost thawing, or in a location based in the mountains, we don’t have to deal with sea level rise hazards).
• Industry, by selecting climate hazards based on the possibility of significant adverse effects on the performance of the economic activity (for example, a cement manufacturer typically doesn't need to be concerned about enduring shifts in wind patterns affecting its production sites).

It is only necessary to evaluate the materiality of risks associated with the selected hazards. Therefore, it is highly efficient to initially eliminate hazards that do not impact the production site.

2. Implementation phase

a. The risk assessment is performed in four steps:

• Exposure Analysis to current and future climate hazards.
• Sensitivity Analysis: Determining how sensitive the assets and business activities are to the identified hazards.
• Evaluating Gross Risks: Understanding the full extent of the risks, a function of exposure, and sensitivity.

The degree of risk is shaped by the interplay between vulnerability, exposure, and hazards.

• Vulnerability represents a predisposition to being adversely affected (IPCC 2012); it is a combination of sensitivity, which seeks to qualify the strength of the system to face external shocks, and adaptive capacity, which is the ability to recover from damage caused by a climate event.
• Exposure is the presence of system assets in places that could be adversely affected. In other words, we have to both consider the location of the asset, as well as its intrinsic characteristics.
• One needs to understand the risks of what hazards could occur on the site, how the asset is constructed, and whether its design features, engineering, and materials are resilient or vulnerable to climate change.

Different geographical locations face varying climate hazards in terms of frequency and intensity. To accurately rank exposure, we use tools that offer a comprehensive view of global climate risks over time. They are aligned with the latest IPCC AR6 report, utilising joint SSP (Shared Socioeconomic Pathway) - RCP (Representative Concentration Pathway) scenarios that integrate socioeconomic factors with climate projections, providing a detailed and nuanced assessment of future climate risks. It is not necessary to consider every scenario to cover the range of potential futures. Due to smaller variances among scenarios up to mid-century compared to the variations within a single scenario, we interpret that it suffices to examine both an optimistic and a pessimistic case.

The sensitivity analysis involves a systematical evaluation of each combination of system element-climatic hazards. Considering the potential impact of each climatic hazard on each system element identified, the assessor assigns proper sensitivity scores. The scores are based on sensitivity scales that can be either qualitative or quantitative ratings. For example, a building is highly sensitive to fires since it may be totally destroyed, while indoor equipment is not very sensitive to changes in wind patterns. As much as possible, relevant thresholds should be defined for each level of the sensitivity scale, based on objective criteria.

Risks are subsequently assessed by integrating exposure and sensitivity scores. To visualise these risks, we recommend plotting them on a Risk Matrix (heat map). This process involves transferring to the matrix the exposure and sensitivity scores for each combination of climate hazard - elements at risk. Plotting risks on a matrix offers a clear visual representation of the severity of various risks, aiding in their prioritization.

To determine the most material physical climatic risks, thresholds should be defined at the beginning of the analysis.

b. Identify adequate adaptation solutions to reduce climate risks. To meet the requirements for DNSH to climate change adaptation for economic activity for the EU Taxonomy, it is necessary to identify adaptation solutions for the most material physical climate risks and to present a coherent adaptation plan.

Limitations of a high-level, qualitative assessment and what can we do to overcome them?

The physical effects of climate change are creating or exacerbating numerous risks. Understanding and evaluating these risks can become challenging as the scale of the assessment increases from a single asset (for example a property or a piece of machinery), to the total assets held by a firm or within its portfolio.

• In this case, geospatial analytics could inform the assessment at a more granular level. This can involve using digital geospatial tools to overlay hundreds of digital hazard data information with data on elements at risk, enabling a detailed assessment of exposure in various hazard scenarios. The fact that a company’s value chain or trade route may also be vulnerable to extreme weather events adds a new layer of complexity to this challenge.

Scenario analysis comes in many forms; it can examine how a company might perform over time or how a specific location might face a range of forecasts, each requiring distinct models and assumptions. Quantifying all economic impacts of climate change is highly complex due to numerous secondary and tertiary effects, such as impacts on migration, conflicts, and food availability, making it difficult to estimate worst-case scenarios and long-term physical risks. Enhancing our understanding of overlooked climate risks requires collaboration among climate and economic experts and improved representation of complex systems. Key steps include using existing knowledge for a comprehensive view, identifying and improving gaps in current models, and pursuing a long-term interdisciplinary agenda with robust model testing and targeted funding to address uncertainties and nonlinear consequences.

Conclusion

Many businesses are at relatively incipient stages of their climate journey. They may have started with TCFD disclosures that have largely relied on some generic climate scores.

Now the EU regulators are requiring businesses to think about a broader set of risks and how will these specifically impact their operations.

In the coming years, businesses will face growing demands to not only disclose climate risks within their organization and throughout the value chain but also to measure and articulate climate-related risks and opportunities while aligning their climate action plans with the level of risk they encounter.

Climate risks are complex due to the compounding and cascading impact they exert, resulting in interconnected adverse outcomes for both ecological and human systems. Translating climate model outcomes into actionable insights is challenging, requiring bridging information gaps, fostering interdisciplinary connections, and managing uncertainties associated with future scenarios and the complexity of the global climate system.

To address the evolving challenges of climate change and assist businesses in complying with international sustainability regulations, Forvis Mazars has developed an internal proprietary tool. This tool provides organisations with a unique and streamlined process for conducting qualitative climate risk assessments. At Forvis Mazars, we aim to support you in transitioning from viewing climate-related data as a regulatory obligation, to recognising its value in strengthening your company's resilience to climate change.

The french version of the article can be accessed below.

_{[1] The 6 EU Green taxonomy objectives: Climate Change Mitigation, Climate Change Adaptation, Sustainable Resource Use, Biodiversity Conservation, Pollution Prevention and Control, Transitioning to a Circular Economy.}