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How do climate change risks hit the company’s balance sheet?

07.10.2020

When discussing climate change risks, the first thing that springs to mind is the devastation caused by extreme weather conditions. These are easily imagined sudden events, pictured into the mind through news images. Extreme weather is, however, only the tip of the iceberg. To map the preparedness, management and opportunities, one has to know to look underneath the surface, too. With right strategic choices, the minuses can become plusses.

Climate change risks are divided into physical risks and transitional risks. Physical risks can be both acute and chronic. Acute risks, mentioned above as sudden events, are for example storms, heavy rains and floods. Chronic risks are the problems caused by long-term increases in temperature, drought and sea level rise.

Transitional risks are those caused by changes in legislation, markets, technology and image. Regulation changes can include bans, such as the Finnish ban on coal as a fuel for electricity and heat production by May, 2029. Markets are affected by different encumbrances, such as taxes and charges for emissions or changes in consumer behavioural when people start to avoid certain products.

Technological changes can indirectly impact significantly on some industrial sectors’ demand – for example electric cars increase the demand for batteries but reduce the need for gearboxes, Image risks, on the other hand, are caused by certain sectors or products being stigmatised as climate harming, thus reducing demand and company brand value.

 

Realisation of climate change risks in the balance sheet – from plus to minus

How do climate risks show in a company’s balance sheet? Physical risks can naturally lead to either acute or chronic material goods’ write down on the assets. These physical risks are easy to envisage and even easier to estimate in advance, especially in relation to acute events.

Climate risks are not limited to the asset side of the balance sheet. Climate risks also have an impact on the acquisition of equity and the price of loan capital. More and more lenders require companies to take climate risks into account in the company’s strategy, governance, risk management and reporting. Climate risks are therefore reflected in the price of debt. Similarly, in the context of share issues, institutional investors examine ever more closely what kind of climate risks they may become exposed to by investing in a company.

 

Risk assessments as a core business function – from minus to plus

Climate change does not only lead to risks but it also creates opportunities. The essential question is whether the company is part of the problem or part of the solution. There are several tools for systematically investigating this issue. Probably the best known is the methodology developed by The Financial Stability Board Task Force on Climate-related Financial Disclosures (TCFD).  Application of the methodology identifies how climate change affects companies’ business and what opportunities and risks it brings. At the same time, it visualises how climate change will be reflected in companies’ income statements, balance sheets and financial statements.

In this way climate risks are brought into the hard core of business – which is exactly where they should be examined. At its best, the right strategic choices can create a transformation, whereby the minus becomes a plus.

 

Originally published in Finnish in Directors’ Institute Finland.

Juha Vanhanen

Managing Director, Partner, Member of the Board

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