Since the dawn of the Industrial Revolution, fossil fuels have greased the wheels of commerce. They form the bedrock of modern human society. Most of what we consider the fruits of everyday life (think air-conditioning, same-day shipping, air travel and Netflix) would not have been possible without fossil fuels. Therefore, it is ironic that the thing that made modern life possible in the first place is the very thing that threatens it the most.

“Because extreme weather events grab headlines, it is easy to misconstrue that physical risk is the only game in town.”

Companies need to be proactive and map the geographic locations of their facilities against regions where climate hazards are likely to intensify over the next few decades. Such assessments should be applied to evaluate the physical risk for existing facilities and guide the selection of locations of future facilities.

Because extreme weather events grab headlines, it is easy to misconstrue that physical risk is the only game in town. Managers often assume that so long as the probability of physical exposure of their facilities and supply chains to extreme weather events is low, climate change is unlikely to pose a risk to their business models. There is a belief that business-as-usual will continue. This assumption is wrong. As the world moves to a low-carbon world, companies will be exposed to the second-order effects of the transition.

Transitioning to a low-carbon world

With the signing of the Paris Agreement in 2015 and recent deliberations at the COP26 summit in Glasgow, governments worldwide have committed to limiting global average temperature increase to 2°C compared to pre- industrial levels (in addition to an optimistic target of 1.5°C). Achieving the Paris Agreement commitments will entail, among other things, restricting the quantity of GHGs released into the atmosphere over the next few decades. Barring any surprise breakthroughs in carbon capture technologies to remove CO2 from the atmosphere at scale, governments have essentially committed to drastically reducing their national GHG emissions in a relatively short period.

To add to this, youth-led protest movements such as the Extinction Rebellion and Fridays For Future have brought climate change to the forefront. They have sparked a change in social preferences and are shaping buying behaviour.

When combined, these factors create an environment where businesses will be exposed to the unpredictable financial impacts resulting from a rapid transition to a carbon-constrained economy. Businesses will be exposed to transition risk arising from changes in government policy (such as the implementation of a carbon tax), from the introduction of new technology, from changes in social norms (such as the reputational risk from being perceived as a polluting business) and from changes in buying behaviour (such as a preference for green/climate-friendly products).

These risk elements will have materially adverse impacts on a company’s profitability and long-term viability – the demand for a company’s products and services could be affected, or the company could be forced to incur additional expenditure to reduce carbon emissions.

Though much like physical risk, not every business will be exposed to transition risk to the same degree: there will be winners and losers. Companies likely to be most affected by transition risk tend to have several unifying characteristics:

• They are carbon-intensive
  

  Companies with carbon-intensive operations risk bearing the brunt of punitive carbon pricing regimes and face huge reputational risk from being branded as “dirty” or “polluting” (think Big Tobacco from the 1980s and 1990s).

• They face competition from low-carbon technology competitors
  

  Rapid electrification is transforming business models and facilitating the adoption of new products as clean energy has become cheap and accessible over the past decade. This has short-circuited the transition away from fossil fuel combustion towards clean electricity: it is not surprising that electric car sales reached a record 3 million in 2020, up 40% from 2019³. Companies that continue to rely on fossil fuel combustion either in their production processes (such as in the paper and pulp industry) or as the primary energy source in their products (such as auto manufacturers), despite having facing competition from low-carbon alternatives, are putting themselves at risk of being adversely affected from sudden changes in buying preferences.

• They cannot shift to low-carbon alternatives due to technological constraints
  

  Several sectors such as cement production, steel manufacturing and long-haul airlines are caught in a twilight zone where there is increasing pressure to reduce carbon footprints, yet there are few technological pathways available to make such a transition. As a result, the profitability of companies in these sectors is likely to be impacted if a carbon tax is implemented.

• They have low-profit margins and are unable to pass on costs to customers
  As the use of carbon pricing becomes prevalent, companies across the board are likely to witness sustained, downward pressures on their profit margins. In such a setting, having the power to pass on these additional costs to customers would be a competitive advantage. Conversely, companies operating in sectors with low- profit margins or those unable to pass on costs are at the greatest risk of being adversely affected.
  

A rapid and ambitious transition to a low-carbon pathway to combat climate change will introduce an outsized risk to any company’s profitability and long-term strategy. Add to this the physical impacts of climate change, and one begins to see the true threat posed by climate change.

Companies need to act on “weather-proofing” their business models, especially those operating in sectors that are most susceptible to the physical and transition risks posed by climate change.

What companies can do to adjust to a warming world?

Incorporate climate risk into existing risk management
Climate risk is not a new type of risk but rather a transverse risk: it manifests itself through existing risks and amplifies them. Therefore, for companies with mature risk management strategies, it is essential to incorporate climate risk into existing frameworks and assess the net impact on the materiality of existing risks. For example, climate change could amplify credit risk for a bank that provides loans to infrastructure companies.

Seize opportunities that climate change will offer
The next few decades will not be all doom and gloom. As climate change throws challenges for companies, it will also present opportunities. The birth of a low-carbon economy combined with regulatory interventions and strong customer preferences for climate-conscious products will require new products and business models. Companies that can curtail their GHG emissions by improving resource efficiency and reducing waste will create a competitive advantage.

Facing the inevitable

Amidst a global pandemic, it is difficult to imagine how anything else could pose a more significant threat to our way of life. Yet climate change is poised to do just that. To give the world a fighting chance of limiting the physical impacts of climate change, an energy transition will be required that will be far larger and quicker than any in recent human history. Given how deep the roots of fossil fuels run, no sector will be left unaffected by this transition: only the degree and severity of its impact will vary.

Carpe diem.