Transforming Economies: The Evaluation of Climate Hazards by Businesses

How companies assess climate risks

March 15, 2023 / Prof. Dr. Ute Vanini

Climate change is reality. Even if the effects vary depending on the industry, location and supply chain: it has long been affecting the activities and success of companies.

For example in the form of higher insurance premiums, more expensive raw materials, CO₂-Premiums or necessary structural changes.

The assessment of climate risks poses problems for companies

Risk managers are therefore faced with the task of correctly assessing these climate-related changes for their companies (outside-in perspective). However, climate risks are difficult to describe within the framework of known analysis and assessment models:

They have a much longer time horizon than most other business risks
There are numerous dependencies to other risks
Their impact on business goals is harder to describe using historical data

In addition, risk managers must also assess the extent to which companies themselves contribute to climate change (inside-out perspective), which is new territory for them.

So companies know that climate change-related risks are coming their way – but have problems analyzing and quantifying these risks.

Prof. Dr. Ute Vanini

There is no guidance on how climate risks can be systematically integrated into Enterprise Risk Management (ERM). In the worst case, this circumstance can even lead to less attention being paid to the effects of climate change than to known, more easily accessible risks.

Companies are increasingly aware of environmental responsibility

The Lucerne University of Applied Sciences and the University of Applied Sciences in Kiel have ERM Report 2022 over 300 companies in Germany and Switzerland were asked how they dealt with this dilemma. Some of the results give hope: The majority of companies are already assuming corporate environmental responsibility – motivated both by perceived external pressure, for example due to political measures, legal requirements or specific customer requests, and by internal convictions of company management or employees.

More environmental responsibility in capital market-oriented companies

Unsurprisingly, larger companies take action to meet their environmental responsibilities to a much greater extent than small and medium-sized enterprises (SMEs).

Fig. 1: Average rating of perceived corporate environmental responsibility by company size (Source: Vanini et al., 2023).

Overall, 89 percent of companies somewhat or totally agree with the statement to recycle, reduce, etc. their waste. This is the case for measures to improve the efficiency of water use only for 60 percent of companies.

While many large companies are already being audited by an external body for their environmental responsibility, this applies to only a few SMEs. Larger companies are also more often capital market oriented and are then subject to stricter regulatory requirements with regard to their sustainability management and reporting. In our study, capital market-oriented companies therefore assume environmental responsibility to a much greater extent than non-capital market-oriented companies.

Benefits of perceived environmental responsibility

Companies see an improvement in their image as the main benefit of being more aware of their environmental responsibility, followed by greater attractiveness from the point of view of (potential) employees and customers.

Economic reasons such as greater competitiveness or improved profitability (still) play a subordinate role. However, around two-thirds of the companies surveyed also name obstacles such as excessive costs against greater awareness of their environmental responsibility.

Companies are increasingly affected by the consequences of climate change

There is a general consensus that climate risks (will) affect all companies, even if traditional risks such as market risks as well as strategic and financial risks are considered to be significantly more relevant for one’s own company. Many companies are already reporting increased raw material and production costs, delivery delays, costs for switching to sustainable processes and increased management costs due to increasing legal requirements.

Every tenth company is already reporting a drop in sales, a drop in production and higher additional insurance benefits. However, the negative consequences of climate change are seen primarily as a cost factor and less as a fundamental threat to one’s own business model.

In addition, the relevance of the risks and their possible extent are assessed differently within the company: supervisory or administrative boards as well as risk and sustainability managers rate these risks higher than management. This low relevance assessment by the management is problematic insofar as it would have to release the resources for more intensive management of climate risks and, in particular, would have to question its own business model for possible risks from climate change.

Climate risks are rarely integrated into risk management

The prioritization and assessment of climate risks vary greatly. A third of all companies do not report climate risks at all as part of their risk management, the remaining companies see climate risks as part of an overarching risk category.

In addition, the responsibilities for this risk are not clearly defined. While larger companies arrange the climate risk in particular in sustainability and risk management, in SMEs it is often a task of the management. On the one hand, this is positive, since the topic is then fundamentally anchored high in the hierarchy. On the other hand, there is a danger that climate risks, due to their long-term nature, will be given less priority than current “burning” problems such as crisis management.

Data evaluation problem related to climate risks

Only every second company evaluates its climate risks regularly and consistently with its other risks.
In addition, less than 20 percent of the companies use the classic tools such as scenario and simulation methods.
A third of companies say a lack of available historical data is one of their top valuation challenges.
37 percent have problems with the economic assessment of climate risks.
Almost every second company therefore exclusively uses the self-assessment (“expert opinion”) as a risk assessment method.
In addition, for more than a third of all companies, a lack of skills to analyze and assess climate risk seems to pose a major challenge.

The low level of approval for the use of scenario analyzes is all the more astonishing since there are now a wide variety of scenarios for climatic development and thus for the probability and extent of possible risks. For Germany, for example, the Federal Environment Agency has developed scenarios for temperature, precipitation and wind speeds for the various regions in its climate impact and risk analysis 2021, which could be used by companies. Overall, there is less a data availability problem than a data analysis problem with regard to climate risks.

Further difficulties in assessing climate risks arise from their long-term nature and their numerous, often non-linear interdependencies with other risks. In particular, the assessment of climate risks from the inside-out perspective causes major problems, since the impact of the company on its relevant stakeholders, on society and the environment must be assessed. Not only the direct climate impact of the company (Scope 1) but also effects from the energy supply (Scope 2) and the value chain (Scope 3) must be determined.

Conclusion: Awareness is increasing, evaluation is not very systematic

Overall, the results of the ERM Report show that many companies are more aware of their environmental responsibility and the threat of climate risks. Greater pressure from external and internal stakeholders and greater perceived environmental responsibility also contribute positively to the integration of climate risks into risk management.

This shows that for a comprehensive sustainability transformation of companies, corresponding pressure and regulatory requirements are still necessary.

Prof. Dr. Ute Vanini

So that companies do not only take measures when they are economically advantageous for them. Overall, however, dealing with these topics – especially in small and medium-sized companies – is still not very systematic. There is still a lot of catching up to do, especially when it comes to analyzing the medium to long-term effects of climate risks on one’s own business model and corporate strategy. The assessment and control of climate risks is therefore not a specialist problem for risk managers but a fundamental task for the entire management team.

The full ERM Report 2022 can be downloaded for free via this link be obtained.

literature

Baumüller, J./Gleißner, W. (2020). Quantification of non-financial risks in company-wide risk management, in: GRC aktuell, vol. 3 no. 4, p. 139 ff.

TCFD (2020). Task Force on Climate-related Financial Disclosures – Guidance on Risk Management Integration and Disclosure.

Vanini, U./Sönnichsen, J. (2023). Climate risks – concept, delimitation and integration into risk management. In: RMA (ed.). Yearbook 2022, ESV, Berlin, will be published soon.

Vanini, U./Hunziker, S./Berchold, N. (2023). Effects of environmental responsibility on climate risk management – results of a study of German and Swiss companies. In: Controller Magazin, forthcoming.