Climate risk modeling: What you need to know to get started

Physical risks

Acute physical risks, or those arising from extreme weather events like floods, storms and wildfires, are the risks most companies typically prepare for. These are becoming more frequent and severe because of climate change, and even in the most optimistic scenarios, that’s not expected to reverse itself. But it’s just as important to model the severity and trajectory of chronic physical risks that emerge over a longer period of time—such as higher mean temperatures or rising sea levels—and the impact those can have, for example, on agricultural production or the transmission of diseases. 

Climate modeling tools incorporate future climate change projection data to provide a view of likely physical risks that can have a material impact on businesses. Some of these tools, such as high-level risk ranking models, assign risk scores for locations, but without factoring in how climate change might affect the risk scores over time. In contrast, climate-adjusted peril risk score models incorporate climate change. For example, they assign risk scores based on the threat posed by floods, wildfires and droughts both today and in the future under different warming scenarios. Catastrophe modeling tools, used by the insurance industry, incorporate additional exposure information to provide a view on metrics like physical losses and business interruption.

Transition risks

Transition risks are risks inherent in the large-scale transformation required to shift to a low-carbon economy. Companies face the risk of stranded assets, or assets that turn out to be worth less than expected as a result of the transition to a low-carbon economy. Transition risks also arise from changes in policy, such as a carbon tax, or changes to markets, for example, changing consumer behavior. In a recent survey 76% of consumers told us they will discontinue relations with companies that treat the environment and communities poorly. On the flip side, climate transition also opens up opportunities like business models built on new technologies and solutions, as well as the potential reputational benefits of being a sustainability leader. 

The more robust tools in this category are risk models that assess the potential economic and financial impact of the transition. Others include: alignment models that assess the extent of misalignment with a transition scenario and uses that as a proxy for transition risk exposure; impact models based on greenhouse gas (GHG) emissions associated with a certain business activity; and target-setting models designed to help investors define a climate strategy for investing. 

In any model, scenario analyses should be used so that companies can be prepared to modify strategies to be resilient no matter what the future looks like. The scenarios range from the best-case one of limiting temperature rise to 1.5° Celsius (compared to pre-industrial temperatures) to the worst-case “business-as-usual” scenario.