How climate risk modelling unlocks business value 

---

Climate risks are no longer hypothetical. They are real, measurable, and increasingly volatile. From weather events such as floods, droughts and changing rainfall patterns to regulatory shifts such as carbon pricing, climate risk exposures affect every business. They also come with unique risks and opportunities. Thus, it naturally follows that businesses should best understand how these exposures affect them and develop appropriate responses. Climate risk modelling helps achieve this by exploring multiple future climate scenarios. Under these scenarios, the potential upside and downside impacts of evolving climate change conditions on the business and its key operations are assessed. 

In this blog, we will discuss climate risk modelling and how it can help unlock value for businesses by supporting four key areas: balance sheet management, risk appetite setting, capital allocation and investment planning, product development and innovation. 

By the end of this article, we hope you will better appreciate that climate risk modelling can be a key strategic differentiator for your business, regardless of sector.  

How can climate risk modelling help businesses capture value?  

Climate risk modelling has traditionally been viewed as a compliance exercise. Below, we zoom in on how a business can apply it to achieve benefits beyond only compliance. 

Balance sheet management: 

Simply put, balance sheet management is how a business manages its assets and liabilities to optimise them for financial stability and long-term value creation. For climate risk modelling to support efficient balance sheet management, it is crucial to consider the impacts of climate risks on both the assets and liabilities of the business.  

The climate risk exposures relevant to the business, such as exposure to high-emissions sectors and extreme weather, are identified and mapped to the specific assets and liabilities. It is also important to look along the business supply chain and value chain to identify where the business is most sensitive to changes in climate-related risks and opportunities. This would help the business have a view on how its key operational dependencies could be impacted. The climate scenarios adopted by the business will support modelling how and when these risks materialise. The climate exposures are then translated into financial impacts on the assets and liabilities through various channels such as the repricing of carbon intensive assets, business interruption costs, and impairment of assets.  

These financial impacts are fed into the balance sheet to give the business a view of how the balance sheet evolves over time under different scenarios. By understanding its key climate risk exposures and taking appropriate steps to adapt to or mitigate them, the business can adjust its balance sheet to ensure there is sufficient capital to support its financial stability and long-term strategy. 

How balance sheet management could be applied: 

Financial institutions (banks, insurers, investment funds) face increased risk of financial losses under climate risk scenarios with high risk¹. In 2023, the European Supervisory Authorities (EBA, EIOPA, and ESMA) and the European Central Bank (ECB) performed a one-off climate stress test on the EU financial system under the Fit-for-55 climate policy package².  
 
The stress test assessed the impact of transition risks and adverse macroeconomic factors on financial institutions such as banks, insurers, investment fund etc. The results of the analysis, as illustrated below, revealed that the worst financial losses were experienced in the scenario that combined transition risks with adverse macroeconomic factors³. 

Table 1: Summary of the results of the 2023 climate stress test exercise.

At first glance, these average impacts do not seem too shocking. The large financial institutions included in the climate stress test exercise above would have balanced and diversified portfolios. However, this would not be the case for individual businesses, solo businesses, or small and medium enterprises where specific climate risks and shocks could be catastrophic.  

Takeaway: The exercise findings show how exposure to carbon intensive assets can drive financial losses under adverse climate risk scenarios. Entities empowered by climate risk modelling can optimise their balance sheets to minimise such financial losses. 

Risk appetite calibration and setting: 

The business can also make use of climate risk modelling to calibrate and set its risk appetite i.e. the amount of risk the business is willing and able to accept. Similar to optimising the balance sheet, translating the climate risk exposures into financial impacts on the balance sheet gives the business a view of its most material climate risk drivers. It is worth mentioning that for now risk frameworks exist, but they are generally silent about climate. As stated above, the impact on the balance sheet can be significant so more and more businesses realise that transposing climate risks through traditional risks (like operational or market risk) is not sufficient to understand their climate risk exposures and impacts. We observed more cases when climate risks are treated as a separate risk dimension with standalone risk budget process and specific limits. The business can then use these insights to determine what levels of exposure to these risk drivers it is willing and able to accept, taking into consideration any of its existing risk mitigation measures.  

How risk appetite calibration and setting could be applied: 

A utility company, through climate risk modelling, identifies the following risks anticipated to materialise under its most extreme climate scenarios: supplier issues halting operations, extreme weather causing equipment to fail and services to be interrupted, fuel prices and energy demand volatility lead to falling profits and updated emissions regulations sharply increase costs of compliance. 
 
Taking these insights into consideration, the utility company revises or puts in place (1) sectoral limits to specify the maximum exposure to high-emissions sectors it will accept as it pursues its strategy (2) geographic limits to specify the maximum exposure to areas affected by material physical risks it is willing to accept for key operations (3) tolerance limits for acceptable levels of losses under climate stresses.⁵ 

Takeaway: Businesses, empowered by climate risk management, can set the maximum climate risk exposures they are willing to accept without jeopardising their key strategic objectives.  

Capital allocation and investment planning: 

Efficient capital allocation and investment planning are essential to businesses for both strategic and operational reasons. Climate risk modelling can support this in several ways. By modelling different climate scenarios of varying degrees of severity, the business can estimate its capital needs under the most adverse scenarios and deploy its resources to minimise the risk of a capital shortfall to acceptable levels.  

The business can also understand the level of exposure to high emissions sectors in its investment books and take steps to increase exposure towards greener assets.  

Climate risk modelling can help the business identify its operations most exposed to disruption from extreme weather. This can subsequently inform the investment planning process on the priority areas for investment in more resilient infrastructure.⁶⁷ 

How capital allocation and investment planning could be applied: 

A real estate company, through climate risk modelling, appreciates that increasingly volatile and dangerous climate puts a significant amount of its real assets at risk.  
 
To address this, the company (1) allocates capital towards developing and implementing resilience and adaptation plans for its most critical sites including adding redundancies to ensure operational continuity (2) ensures all new real estate constructions consider both current and expected future climate developments by opting for the appropriate material and design considerations⁸. 

Takeaway: Insights generated from climate risk modelling can help a business plan for its existing and future capital allocation and investment planning. 

Product development and innovation: 

Climate risk modelling is a growth enabler. The insights developed from it can be fed into the product development and innovation process for a business. These insights inform businesses where to innovate, what to build and when to launch. 

For example, insights generated from modelling the physical risk exposures impacting critical infrastructure can be used to design products and operations with climate-adaptive features. These features help ensure the infrastructure ultimately experiences comparatively reduced impacts and recovery time from extreme weather.⁹  

How product development and innovation could be applied: 

A renewable energy fund manager looking to invest in renewable energy projects can use physical climate risk modelling to identify and select sites for the projects to be built or engineered¹⁰.  
 
The model outputs can also drive investment in resilient design features such as wind turbines that resist hurricanes and typhoons. This can ultimately lead to more risk-informed decision-making and better project outcomes. 

Takeaway: Climate risk modelling is a growth enabler, allowing the business to leverage the insights generated from different scenarios into the product development and innovation process.  

Unlocking value across different sectors 

Table 2 provides an overview of how the insights generated from climate risk modelling could potentially be applied across different sectors. 

Table 2: Examples of how climate insights could potentially be turned into business action

Key takeaway: Climate risk modelling is sector agnostic, applicable across various industries to add value to businesses. 

How are climate risks modelled? 

In December 2024 last year, we released an article on how climate risks are modelled in the financial sector. To recap: when modelling climate risks, financial institutions should define the objectives to be achieved, collect the relevant climate data, perform scenario analysis, integrate the results into financial models, validate and review their model and findings.  

These can be broadly summarised into two principles: (1) understanding the climate risk exposures (2) translating the risk exposures into financial impact. These principles are universal and can even be applied outside of the financial sector. The truth is: building a climate risk model tailored to your business’s unique exposures does require a higher upfront investment—but the value it delivers far outweighs the cost. Below we give an overview of how to model climate risks in line with the principles outlined above. 

We start with the fundamentals. Climate risks can be commonly split into physical risks and transition risks:  

• Physical risks are those that result from direct impacts of climate change, like extreme weather and long-term changes in climate patterns, which damage or interrupt business operations; and 
• Transition risks are those that result from socioeconomic and policy shifts towards a low carbon economy. 

Modelling physical risks (1/2): understanding exposure 

• Map out the geographical locations of all key business areas e.g. assets, business operations, supply chains and value chains; 
• Identify the relevant climate hazards that could affect the key business areas directly or indirectly in these geographical locations. For example, hailstorms or drought for a wine producer business³⁷; 
• Develop different scenarios to capture how the climate hazards affecting the key business areas could evolve differently over time. For example, leveraging the Intergovernmental Panel on Climate Change (IPCC)-recommended Network for Greening the Financial System (NGFS)³⁸ scenarios for these regions as applicable; 
• Form a view (e.g. heat map) of the expected severity of the climate hazards for the key business areas; and 
• Assess each key business area’s vulnerability to the climate hazards.  

Table 3: Mapping key business areas with climate hazards for a wine producer under a high physical risk scenario (e.g. RCP 8.5 scenario) 

Note: In this illustrative case, the wine producer has assessed its most relevant climate hazards are hailstorms and drought. It has modelled how these hazard exposures will evolve in 2030 and 2050 for each key business area by location. L – Low risk, M – Medium risk, H – High risk, VH – Very High risk 

Modelling physical risks (2/2): translating exposures to economic losses 

• Map the climate hazards to risk drivers that affect the businesses e.g. supply chain disruption, losses due to falling crop yields; 

• Quantify the financial impact of the climate hazards on the key business areas based on the severity of the climate hazards and the business vulnerability to the climate hazard e.g. if vineyard relies on irrigation from river water, severe drought will strain water supply, reduce yields, and losses can be estimated from the resulting expected reduction in revenue from the reduced yields; 

• Assess each key business area’s capacity to prevent, respond to and recover from the adverse consequences of the climate hazards; and 

• The economic loss would be the residual financial impact of the climate hazard after adopting mitigation measures. 

Modelling transition risks (1/2): understanding exposure

• Identify the key transition risk drivers applicable to the business and sector of operations e.g. food producers would consider carbon tax impacts on prices of farm inputs such as fuel and fertilisers, investment funds would consider the asset price impacts of markets shifting away from high emissions industries such as mining and utilities; 

• Consider different climate transition scenarios under which the key transition risk drivers evolve differently over time. These scenarios give assumptions on several areas such as carbon pricing, regulatory timelines for meeting emissions requirements etc. For example, the IPCC-recommended NGFS climate transition scenarios; and 

• Link each transition risk driver to specific business activities for example linking higher carbon taxes to increases in fuel-related costs like transportation. 

Modelling transition risks (2/2): translating exposures to economic losses

• Determine the financial impact of the transition risk drivers to the business under each scenario; 

• Assess the capacity of the business to adapt to and recover from the adverse climate transition scenarios; and 

• The economic loss would be the residual financial impact of the transition risk drivers after adopting mitigation measures. 

Table 4: Mapping transition risk drivers with climate hazards for different transition risk scenarios 

Note: In this illustrative case, the wine producer has assessed how the financial impact from two transition risk scenarios will evolve in 2030 and 2050 by scenario and transition risk driver. The financial impacts are expressed in terms of total losses as a percentage of the in-scope transition risk exposures. 

Conclusion 

Climate risk modelling has traditionally been viewed as a risk management and regulatory compliance exercise. However, based on our experience, the ability of a business to incorporate it into its broader decision making can unlock business value and be a key success differentiator. The multiple use cases a business could derive from effective climate risk modelling can be leveraged by all key decision-makers in their areas of expertise. This underscores that climate risks can manifest universally.  

Now is the time for businesses to integrate climate risk modelling into their core strategy and long-term planning. A good way to start would be to assess your top three physical and transition risk exposures and progress from there. 

What we think

Notes

---