Why Climate Change and Nature Matter for Investments, and Corporate Climate Risk Mitigation

By CPA Margaret Kibera

Climate risk is the potential for negative impacts on financial assets, business operations, infrastructure, and ecosystems due to climate change. Early Awareness of climate risk began gaining attention in the scientific community in the late 20th century. Establishing the Intergovernmental Panel on Climate Change (IPCC) in 1988 was a significant milestone, providing scientific assessments of climate change and its potential impacts from the 1990s to early 2000s. During this period, climate risk was discussed more in policy circles and among environmental groups. The Kyoto Protocol (1997) was a landmark international treaty aimed at reducing greenhouse gas emissions, marking an early effort to address climate risks on a global scale.

In the mid-2000s – 2010s, the Financial and corporate sectors began recognizing the importance of climate risk. Reports like the Stern Review (2006) highlighted the economic implications of climate change. The Task Force on Climate-related Financial Disclosures (TCFD), established in 2015, provided a framework for companies to disclose climate-related financial risks. In the 2020s and Beyond, Climate risk has become a central issue for corporations, investors, and policymakers. Increasingly, companies are expected to integrate climate risk into their strategic planning and financial reporting. In 2023, we saw the introduction of IFRS S1 andIFRS2, which aim to establish a comprehensive global baseline of sustainability-related financial disclosures and a common language for sustainability information which will enable comparable and consistent sustainability disclosures across global capital markets, thereby meeting the information needs of primary users of general-purpose financial reports concerning sustainability-related risks and opportunities.Entities must disclose significant sustainability-related risks. Climate risk can be broadly categorized into two types: (1)Physical Risks-Direct damage caused by climate change-related events, such as extreme weather, rising sea levels, and changing precipitation patterns. These events can lead to property damage, supply chain disruptions, and increased operating costs. (2) Transition Risks– Financial and operational risks associated with transitioning to a low-carbon economy. This includes regulatory changes, shifts in market preferences, technological advancements, and reputational risks as consumers and investors increasingly favour sustainable practices.

Why climate change and nature matter for investments

Climate change and the state of natural ecosystems are becoming increasingly critical factors for investors. Understanding these elements is vital for evaluating risks and opportunities within financial portfolios. Investors must consider climate change and natural ecosystem health integral to their risk assessments and investment strategies. The risks profoundly and widely impact the economy, business operations, and financial markets. By understanding and mitigating these risks, investors and corporations can make more informed decisions that promote sustainable economic growth and stability. Below, we delve into the specific reasons why climate change and nature matter for investments.

Nexus between Environment, Nature, and Economic Growth

1. Resource Dependency: Economic growth heavily depends on natural resources such as water, minerals, and agricultural products. Depletion or degradation of these resources due to environmental damage can hamper economic activities and lead to increased costs and supply chain disruptions.
2. Ecosystem Services: Nature provides essential services like pollination, water purification, and climate regulation. Disruption in these services can lead to increased costs and reduced productivity, which are crucial for various industries. The degradation of these services can impact productivity and economic stability.
3. Sustainable Growth: Sustainable environmental practices can promote long-term economic growth by ensuring resource availability and reducing environmental degradation, hence ensuring healthy ecosystems. Conversely, unsustainable practices can lead to economic decline and increased costs for businesses and governments. Investments in green technologies and sustainable practices can lead to innovation and new market opportunities.

The impact on Poor People: Most-Implications on Financial Inclusion

1. Vulnerability to Climate Change: Poor communities are often more vulnerable to the impacts of climate change, such as extreme weather events, because they lack the resources to recover from disasters.
2. Economic Inequality or Disparity: Climate change exacerbates economic disparities and inequality by disproportionately affecting the livelihoods of the poor, leading to greater inequality, environmental degradation and limited access to adaptive resources.
3. Financial Exclusion: The increased vulnerability of poor communities can lead to higher credit risks, making financial institutions reluctant to provide loans or insurance to these populations. This perpetuates a cycle of poverty and economic exclusion.
4. Social Stability: Economic instability in vulnerable communities can lead to social unrest, affecting broader economic stability and investment environments.

Climate Change and Nature Can Translate into Credit Risk

1. Operational Disruptions: Climate events such as floods, hurricanes, and droughts can disrupt business operations, affecting revenue streams and increasing default risks.
2. Sector-Specific Risks: Industries reliant on natural resources, such as agriculture, forestry, and fisheries, are particularly at risk. Environmental changes can reduce productivity and profitability, impacting their ability to service debt.
3. Agricultural Impact: Changes in climate can adversely impact agricultural yields, affecting loans in the agricultural sector.
4. Insurance Costs: Increased frequency and severity of climate events can lead to higher insurance premiums and reduced coverage availability, impacting borrowers’ ability to secure financing.
5. Default Risk: Businesses and individuals affected by climate change may struggle to repay loans, increasing default rates.
6. Regional risks: Geographic areas prone to extreme weather events or environmental degradation may experience higher default rates, impacting regional economic stability and increasing credit risks for lenders.

Physical Risks Have Impact on Assets Values

1. Property and Infrastructure Damage: Physical risks like extreme weather events such as hurricanes, floods, and wildfires, can damage physical assets like buildings, roads, and bridges, leading to significant financial losses, reducing their value and leading to significant financial losses.
2. Devaluation of Properties: Properties in areas prone to environmental risks may lose value as the frequency and severity of such events increase.
3. Supply Chain Disruptions: Physical risks can disrupt supply chains, leading to increased costs and loss of business continuity.
4. Market Volatility: Physical climate risks can lead to increased volatility in financial markets as investors react to the potential and actual impacts on asset values.
5. Insurance Costs: Rising insurance costs to cover physical damages can reduce the profitability of owning and operating assets in high-risk areas.

Transition Risks Can Lead to Stranded Assets 

1. Regulatory Changes: Transitioning to a low-carbon economy involves regulatory changes that can make certain assets obsolete, less valuable or unprofitable such as coal mines fossil fuel reserves or oil reserves.
2. Technological Shifts: Advances in green technologies can render existing technologies and investments obsolete. That is innovations in renewable energy and energy efficiency can render traditional energy sources less competitive, leading to stranded assets.
3. Market Shift or Preferences: Changes in consumer preferences towards sustainable products can impact the demand for certain assets, leading to stranded assets in unsustainable industries. This is because consumer preferences are shifting towards sustainable products and services. Companies failing to adapt may find their assets becoming obsolete.

Liability Risks -People May Sue if They Suffer Physical & Transitional Risks

1. Legal Claims: As awareness of climate change grows, there is an increasing likelihood of legal claims against companies for contributing to climate change or failing to mitigate its impacts. companies may face lawsuits if they are found liable for contributing to climate change or environmental damage that results in physical or economic harm to individuals or communities.
2. Reputational damage: Legal battles and public scrutiny can harm a company’s reputation, affecting its market value and investor confidence. This may result in financial instability and potential losses.
3. Financial Penalties: Companies found liable for environmental damages or failing to comply with regulations may face substantial financial penalties, affecting their profitability and valuation. Successful litigation can result in poor financial health of the company.

Corporate Actions to Mitigate Climate Risks

Climate risk is an increasingly significant concern for both the public and private sectors. Recognizing and addressing these risks through proactive measures is crucial for ensuring long-term sustainability and resilience in the face of climate change. As awareness and regulatory pressures grow, corporations are expected to play a vital role in mitigating climate risks and contributing to a sustainable future.

Corporations are taking various steps to mitigate climate risk, which include:

1. Emissions Reductions: Setting targets to reduce greenhouse gas emissions through energy efficiency, renewable energy adoption, and sustainable practices. Many companies have committed to achieving net-zero emissions by specific target years.
2. Risk Assessment and Disclosure: Conducting climate risk assessments and disclosing findings in alignment with frameworks like the TCFD, IFRS S1 andIFRS2. This helps investors understand how companies are managing climate risks.
3. Sustainable Supply Chains: Implementing sustainability criteria in supply chain management to reduce carbon footprints and enhance resilience against climate-related disruptions.
4. Investing in Resilience: Building infrastructure and adopting technologies that enhance resilience against physical climate risks, such as floods, storms, and heatwaves.
5. Green Financing: Issuing green bonds and securing sustainable financing to fund environmentally friendly projects. This also includes divesting from fossil fuels and investing in renewable energy and sustainable technologies.
6. Innovation and R&D: Investing in research and development of new technologies and products that contribute to sustainability and reduce environmental impact.
7. Stakeholder Engagement: Engaging with stakeholders, including customers, employees, regulators, and communities, to promote sustainability initiatives and foster collaborative efforts to combat climate change

 Margaret Kibera is an Accountant, Financial Analyst, Lecturer and former Banker. She is a part time lecturer at Jomo Kenyatta University of Agriculture and Technology, and is currently writing her PHD Thesis in finance.