What is climate risk, and how can we manage it?

There’s an old saying about financial markets: they go up and down like a toilet seat. In other words, investors must be braced for constant turmoil and the many risks that come with their search for monetary rewards.

But today, those risks have become much more challenging than ever to assess, as the whirlwinds of the climate crisis blow every forecast into disarray and spread uncertainty around the globe.

So, how can investors – particularly those with a concern for the environment and sustainable development – navigate this maelstrom of climate risk? How can we assess current and future risks to investments?

In this guide, we cover all the key questions around climate risk, including what it is, how it’s measured, the problem of risk tipping points, and which countries are facing the greatest risks.

What is climate risk?

According to the Principles for Responsible Investment (PRI), there are broadly two kinds of climate risks to investors.

One is physical risk, which is what happens when the climate crisis causes increasingly destructive – and frequent – disasters. This may include large-scale flooding that wipes out productive farmland and drives up food prices globally, or massive wildfires that destroy vast swathes of forests, ravage biodiversity and threaten communities.

The other type of risk is known as transitional risk, which refers to the reactions and changes that firms, governments and even consumers are making in response to climate impacts. For example, many governments are working towards achieving net-zero carbon emissions over the next few decades.

In response to such policies, companies could shift investments out of carbon-intensive industries into green energy industries and carbon-free energy sources. Similarly, consumers could adjust their shopping habits, such as installing solar panels at home, buying electric cars, or using public transport instead of driving.

While these changes won’t happen immediately, they’re expected to have a major impact on financial markets and investments in the near future. “Both types of risk may affect firms’ revenues and expenses, asset and liability values, and/or availability and cost of capital,” warns PRI, an investor initiative created in partnership with the United Nations Environmental Programme Finance Initiative and the United Nations Global Compact.

On top of that, investors are increasingly demanding that companies declare their exposure to climate-related risks and make firm commitments to sustainable policies so they can make better investment decisions. Investors may also demand that companies disclose the results of vulnerability assessments, including secondary impacts such as business interruption.

What are risk tipping points?

You may already be familiar with the concept of climate tipping points, which are small changes in the climate that could have major repercussions globally.

Now, researchers at the United Nations University (UNU) have pointed out a different type of tipping point, known as risk tipping points. These are thresholds that, once crossed, would make it significantly harder for humanity to adapt to the climate crisis and the risks it brings.

One example is extreme heat and humidity. Humans can adapt to high temperatures to a certain extent by sweating – but only up to a certain limit. Some parts of the world, such as the Arabian Gulf, are at risk of breaching that limit by the end of this century, making them potentially unlivable.

In another example of a risk tipping point, damage from climate-related disasters has increased sevenfold since the 1970s, causing USD 313 billion in global economic losses in 2022 alone. Now, insurance premiums are skyrocketing in flood-prone areas, and some insurers have already decided to stop covering homes and property in the highest-risk areas.

Insurance loss and extreme heat are just two of the risk tipping points named in the UNU study, which also mentions mass extinction, groundwater depletion, glacial melt and space debris.

“Human actions are behind this rapid and fundamental change to the planet, driving us towards potential catastrophe,” it concludes. “Luckily, we are able to see the danger ahead of us. Changing our behaviors and priorities can shape a path towards a bright, sustainable and equitable future.”

How can we manage climate risk?

With so many climate risks now at play, how can we protect ourselves from them? An important first step is to assess the main threats and then work towards mitigating and adapting to them. Many governments are commissioning national and regional climate risk assessments to guide public policy.

The U.S., for instance, has produced National Climate Assessment reports since 2000, while the E.U. is set to publish the first European Climate Risk Assessment in spring 2024. At a global scale, the Intergovernmental Panel on Climate Change (IPCC) also publishes regular assessments on climate change impacts, adaptation and vulnerability.

Some experts also point to the importance of anticipating risks and developing adaptive responses before climate disasters strike. For example, in 2000, a famine early warning system, integrating climate forecasts with other information such as harvest assessments, was installed in Ethiopia in time to prevent disaster by drastically increasing food aid from donor countries.

Many investors, for their part, are moving their money to less carbon-intensive industries, working with investee companies to decarbonize, and working with policymakers to put an accurate price tag on climate risk. PRI has produced this Investor Resource Guide to help investors navigate this new field.

Which countries are facing the greatest climate risk?

While the climate crisis is already affecting people and ecosystems all over the world, some are more vulnerable than others. Some of the world’s poorest and most politically unstable countries are also those with the least capacity to adapt, such as Somalia, Syria, the Democratic Republic of Congo, Afghanistan and Yemen.

At the same time, some parts of the world are particularly exposed to climate-related disasters such as hurricanes and cyclones. According to the Global Climate Risk Index produced by Germanwatch, Puerto Rico, Myanmar, Haiti, the Philippines and Mozambique bore the greatest human and economic toll of climate disasters between 2000 and 2019.

But that doesn’t mean everyone else, including investors, in our interconnected world can relax and assume they are safe. Europe is warming faster than any other continent in the world and is already facing regular heatwaves and wildfires, as well as drought and glacial melt. The U.S., meanwhile, suffered at least USD 165 billion in damage from climate disasters in 2022 alone.

And as humanity grows ever closer to crossing multiple climate and risk tipping points, one thing is clear: these climate risks will only continue to grow unless we act quickly to mitigate and adapt to them.