What are climate physical risks? Overview and key points of analysis

The risks faced by companies due to global warming can be broadly divided into physical risks and transition risks. Physical risks are risks caused by physical phenomena caused by climate change such as sea level rise and abnormal weather, while transition risks represent the financial risks associated with the transition to a low-carbon society. As then-Prime Minister Kan declared carbon neutrality by 2050 in 2021, many companies have begun to take measures at an accelerated pace with regard to transition risks, even in Japan, but responses to physical risks have been delayed.

As I have introduced in past columns, the effects of climate change are beginning to have a significant impact on corporate finances through the intensification and frequency of various natural disasters. In order to minimize the impact on corporate finances and earnings as much as possible, to fulfill accountability to investors and to smoothly receive investments and loans, it is necessary to assess and disclose information on the physical risks of companies and value chains.

In order to accelerate measures against physical risks, it is necessary to establish methods for assessing the financial impact of physical risks. Without proper valuation, there will be undesirable consequences for both investors and companies. For investors, there is a risk that investing in a company with a large physical risk will lead to losses when risks materialize in the future, while for companies, there is a risk that not disclosing information on physical risks will lead to a low corporate valuation from the market.

Against this background, in order to help with physical risk analysis, this column explains how to assess the financial impact of physical risk.

Physical Risk Classification

Physical risks are classified into acute risks (such as cyclones and floods), which are risks caused by events caused by extreme weather, and chronic risks, such as sea level rise and heat waves, which are risks due to changes in climate patterns over time.

From the perspective of a company’s business activities, it can be classified into “direct risk” in which the physical assets held by the company are directly affected, and “indirect risk” in which stakeholders in the value chain are affected.

Physical Risk Analysis Procedures

Next, we will explain the steps to actually make the financial impact of physical risk. There are three main stages.

1. Risk Identification and Analysis

While it is common to identify risks by acute/chronic classification, it is also possible to grasp risks based on the characteristics (industry and region) of a company.

Examples of industry-specific risks include:

• Agriculture: Crop yields are declining due to climate change
• Insurance: Increasing uncertainty makes it difficult to price products

Examples of region-specific risks include:

• Higher latitudes: Higher temperature increases (e.g., twice as high temperature in Canada as elsewhere)
• Flat lowlands and locations close to rivers: the risk of flooding is high due to the difficulty of natural drainage

And so on. It is also useful to organize according to the value chain. Upstream including procurement of raw materials and parts, downstream including product supply to the market, and other risks of infrastructure-related companies can be sorted out. You need to take advantage of these angles to identify the key risks that your company has.

By analyzing the magnitude of each risk, it is possible to estimate the importance (materiality) to the company. First of all, it is important to analyze qualitatively, quantify the items that can be quantified as much as possible, and to be able to objectively explain the importance of the risk.

As shown in the figure below, risk can be expressed by multiplying three factors: hazard (size at the time of occurrence), exposure (target value, etc.), and vulnerability. When analyzing the impact of climate change, it is most important to estimate the magnitude of hazards, but the lack of access to data is a major challenge. For information on flood risk analysis methods, please refer to another column, “Flood Risk Assessment Methods and Data Accuracy Required for TCFD Disclosure.”

2. Organizing measures

There are two types of climate change countermeasures: mitigation measures to reduce and absorb greenhouse gas emissions, and adaptation measures to prevent and mitigate climate change impacts and to take advantage of new climatic conditions. Furthermore, each measure can be classified into two categories: those that are carried out mainly by local governments for public infrastructure, and those that are carried out by individual companies as a main body in relation to their own projects. From these two axes, countermeasures can be organized as shown in the following figure.

3. Physical Risk Assessment and Response

Finally, with regard to the risks identified in 1., we will summarize the impact of taking the measures organized in 2. The magnitude of the potential impact on finances is organized in three stages: large, medium, and small.

In addition, we will introduce methods for assessing the impact of these financial impacts on corporate value calculations. A commonly used method in enterprise value calculation is the DCF method (Discounted Cash Flow method). Since the financial impact can be quantitatively assessed in detail, it is ideal to forecast future cash flow and adjust discount rates based on this calculation method to reflect it in corporate value.

Finally, as a conclusion, we will show an example of an analysis according to the evaluation procedure from 1. to 3. (example of a virtual car manufacturing company). This is just one example, but please refer to it.

Examples of Responses to Physical Risks

Some companies have already begun to respond to the physical risks posed by climate change.

In the materials disclosed under the TCFD, Kirin identifies risks, assesses risks, and organizes strategies based on them. It can be seen that very detailed analysis has been performed, such as the impact on the yield peculiar to agricultural businesses and the water risk analysis of factories by region. In addition, it quantitatively shows the financial impact of each risk, and it can be said that it is the highest level of disclosure among Japan companies.

It is also excellent that this risk analysis was actually immediately reflected in the business. In response to the results of the TCFD analysis, the disaster manual was reviewed, and it is stated that it was possible to avoid major damage to the company by Typhoons No. 15 and No. 19 in 2019. In addition, since we learned that the raw materials of Kirin’s main beer, will have a major impact on the termination due to climate change, we are developing new brewing and cultivation technologies, and carefully explaining that we are adapting our strategy to climate change quickly, giving the impression that we are a sustainable company that is strong against climate change.

Ricoh briefly summarizes its analysis and assessment of physical risks in the table below. We have established evaluation items such as financial impact and urgency, and evaluate each of them in three stages. It is also characteristic that we discuss in detail the measures that are currently being carried out and will be taken for each item. Ricoh has established an in-house Risk Management Committee, quantitatively estimates the risk level based on the amount of impact, determines the risk management level according to the magnitude, and has built a mechanism to utilize it in management, and is already making adjustments to the increase in natural disasters that are considered to be highly urgent because “necessary construction such as the installation of water stop plates and waterproof walls will begin from fiscal 2021.” Not only that, but we are also developing new businesses with our own systems as adaptation services and taking advantage of risks as opportunities, and we believe that we are a forward-thinking company in terms of both information disclosure and response. For details, please refer to the Ricoh Group’s TCFD Report.

Climate Risk Analysis Application Climate Vision

“Climate Vision”, a climate risk analysis application developed by Gaia Vision Co., Ltd., is a web service that can easily perform this flood risk analysis, and is a revolutionary solution that can significantly reduce the burden of TCFD analysis for companies at a low price. If you have any problems with climate physical risk analysis or information disclosure, please contact us.

Bibliography

• [1] Investor Leadership Network, CLIMATE CHANGE PHYSICAL RISK TOOLKIT, https://investorleadershipnetwork.org/wp-content/uploads/ILN-Climate-Change-Physical-Risk-Toolkit-v6.pdf, Viewed on 2022-10-12
• [2] Kirin Holdings Co., Ltd., Disclosure based on TCFD recommendations, https://www.kirinholdings.com/jp/investors/files/pdf/kirinER2022_TCFD_0909.pdf, Viewed on 2022-10-13
• [3] Ricoh Corporation, TCFD Report, https://jp.ricoh.com/-/Media/Ricoh/Sites/jp_ricoh/environment/management/tcfd/pdf/TCFD_report_web.pdf,Viewed on: October 13, 2022