Building Climate Resilience
“Most of the world’s homes, businesses, and infrastructure were built to meet the needs for a 20th Century climate. As the effects of climate change accelerate, the need to prepare for the more intense events of tomorrow becomes more urgent with each passing day.” i
The business case for building resilience to the changing climate can be made primarily in terms of avoiding unexpected costs, managing risks and making the most of opportunities, although the focus is on the former. Organizations will ultimately need to improve their control environment by designing improved risk mitigation plans.
The reasons for this include the fact that weather events can be very costly with regards to lives, money, security, internal morale and reputation. Good risk management practices should allow for early recognition of threats so as to empower the organization to classify and highlight the risks. The organization can then deal with the threats in an effective and timely way.
In the context of disaster risk reduction, the UN defines resilience as “the ability of a system, community or society exposed to hazards to resist, absorb, accommodate, adapt to, transform and recover from the effects of a hazard in a timely and efficient manner, including through the preservation and restoration of its essential basic structures and functions through risk management.”ii
Risk management often achieves this through the promotion and facilitation of improved communication between employees, management board and stakeholders concerning how the threats are being managed.
The changing climatic conditions are leading to a wide range of threats. It is important for organizations to recognise and assess the associated volatility of physical risks. Understanding these threats can also present opportunities with a positive impact on business performance.
There is general consensus that Physical Risks of climate change that are associated with natural events, such as storms or floods, can inflict both direct damage and indirect impacts to businesses. We can generally split these into two main risk types:
• Acute – Extreme weather events - Floods, windstorms, wildfires, etc
• Chronic – Changing climate conditions/patterns – Droughts, heatwaves, coastal erosion, etc.
This split is very important in the context of building resilience as organizations will need to develop different approaches and solutions for each type of physical risks.
While no one has yet discovered how to play God, there are a range of both preventive and reactive risk management controls and solutions that can be developed to reduce the impact on business. These are often referred to as pre- and post- loss mitigation strategies, such as business continuity plans and insurance, which seeks to protect income affected by unfavorable weather conditions.
Another consideration is that while identifying and assessing climate change risks for most organizations these may change depending on the respective geographical location. Companies with global operations therefore need to assess their risk profile across each territory and region of their respective activities.
Physical weather risks and climate change
Many industries are at risk of the effects of normal weather fluctuations, as well as the acute and chronic types of physical risks that were outlined earlier.
Table 6.1 summarises some of the key industries and the reason why they have exposure to different climate risks. The table provides details of the risk event and impact on the industry concerned and provides a basis for an organizations to develop climate scenarios that can be assessed and mitigated Perhaps surprisingly even organizations involved in producing new types of renewable forms of energy, such as solar and wind, are themselves vulnerable to physical climate risks, such as hail and lack of wind respectively.
The analysis highlights the range of physical climate risks and the fact that organizations need to carefully consider both acute and chronic types, that can also be classified as catastrophic and non-catastrophic types of exposures.
6.2 BUILDING CLIMATE RESILIENCE
When building operational resilience developing pre- and post-loss event operational controls is important in the context of reducing the severity or financial impact of physical risks due to climate change.
It is important to firstly understand the context of what is meant by resilience and then to consider what controls can be designed to help organizations improve their resilience to climate change physical risks. Resilience can be grouped into different areas of focus. This chapter will focus on three broad categories namely operational, financial and strategic resilience.
6.2.1 Operational resilience
The primary objective of operational resilience is the ability of the organization to continue to deliver critical operations, i.e. product and services, throughout a disruption. Operational resilience is really linked to the ability of an organization to prevent, adapt, respond to, recover, and learn from operational disruptions.
A business service is defined as “a service that an organization provides to an external end user”. It is deemed ‘important’ if it’s disruption would materially impact an organizations’ (financial or operational) viability, cause significant harm to customers or impact a firm’s ability to deliver the Board’s approved strategy.
Essentially, it is all about ensuring that an organization has appropriate contingency plans and risk mitigation strategies in place. Why? So that organizations are as prepared as possible for adverse scenarios. This should prevent harm from manifesting or will help the recovery if something does go wrong.
Regulators expectations also extend to the fact that building operational resilience is necessary to protect the wider society and consumers. Financial regulators for example states that “Operational resilience is also about changing your organization’s mindset. Instead of thinking about operational disruption as something that could happen, firms should assume it will happen. This shift in attitude should propel your organization to make operational resilience a priority and will help to drive cultural change within the industry.”iv
The key components or control mechanism that will be covered in this chapter include:
• Business Continuity and Crisis management
• Supply Chain Risk management
6.1.2 Financial Resilience
Financial resilience is the ability of an organization to withstand events that affect their capital structure, liquidity, revenue and assets.
Organisations can design pre- and post- loss controls that they can use through risk financing mechanisms. This will be either pre-financing of losses from climate events or through insurance and hedging strategies. Both arrangements will seek to reduce volatility of earnings that can in turn help to provide other financial benefits and targets, such as:
• Stronger credit ratings
• Lower cost of debt
• Improved access to funding.
Furthermore, eliminating or reducing the uncertainty generated by different non-core risks allows management to concentrate on executing core business strategies. Physical risk from Climate change is mainly linked to the uncertainty in cash flow and earnings caused by volumetric risk (which is variability in supply and/or demand caused primarily by variability in the climate conditions).
With growing awareness of the impact of weather risk due to, for example, temperature changes and associated volatility, stakeholders and analysts can view physical risks from climate change as a non-core operating risk that needs to be addressed through the use of insurance or other risk financial techniques such as hedging instruments.
Stakeholders and analysts have less tolerance for excuses made by managers who have left their companies exposed to climate change risk. Indeed, in certain climate sensitive industries, such as the gas industry, ignoring weather risk is no longer considered acceptable.
As awareness of climate risk increases among shareholders, Chief Executives are no longer able to use the climate as an excuse for lower profits. As a result, a growing number of companies are developing risk financing solutions to hedge specific exposures. In this chapter in section 6.7 we expand on some of the risk financing mechanism available for companies including the use of captive insurance companies and of innovative solutions such as parametric or index solutions.
The key components or control mechanism that will be covered in this chapter include:
· Risk Financing
· Strategic insurance Risk Gap Analysis
· Financial Planning and Capital management
6.2.3 Strategic Resilience
Strategic resilience considers the implications of the strategic and organisational choices a firm has to make, and the potential implications for long term stability.
One of the most important techniques is to develop an emerging risk management framework that is outlined in Chapter 8 and using tools and techniques such as horizon scanning. Emerging risks are those that you can see approaching but are not yet sufficiently clear to enable a formal impact and likelihood risk assessment. However, the key is to understand emerging risks as best as possible. Consider monitoring them to ensure they don’t arise unexpectedly and consider any possible cost-effective actions that can be taken now to prepare for when the risks materializes.
The emerging risk management framework should feed into strategic and operational planning processes to support strategic decisions that need to be made and considering the funding of any mitigating actions or steps needed. From a Climate Change perspective this is likely to center on the potential for customers’ needs or markets to change due to climatic changes or transitional influences, geographical footprint, supply chain transformation over time and/or access to capital, especially for those impacted by transition. The following example helps to illustrate the important of developing strategic resilience.
There key components or control mechanism that will be covered in this chapter include:
• Emerging Risk Management Framework
• Strategic Planning
DEVELOPING A CLIMATE RESILEINCE FRAMEWORK
Figure 6.1 provides a broad outline of a climate resilience framework that can be used to improve resilience across operational, financial and strategic dimensions.
The framework helps to explain the main controls that organizations should seek to develop and the associated tools and techniques. Some of the traditional controls for building operational risk will be covered in this chapter, such as the use of business continuity planning and insurance.
A number of tools are available within the Risk Manager’s ‘toolkit’, to enable them to assess and control risks facing an organization
One of the most important tools for building climate resilience is stress and scenario testing However, it is important to note the importance of stress testing and scenario analysis to climate resilience both in understanding the nature of potential events and the steps needed to build operational, financial or strategic resilience. The techniques vary slightly but the principles apply equally across all three. Operational resilience relies on stress testing to challenge the impact tolerance assessments. Financial resilience relies on it to test sensitivities to key financial shocks. Strategic resilience utilises the technique to ‘war game’ future scenarios.
Another best practice risk management tools is the bow-tie analysis which helps to document, monitor and communicate the risk environment of an undesirable event such as acute climate physical risks. The use of the tool also helps to draw the attention of controls in the prevention and mitigation of negative risk events.
For climate change, they can be used to assess a specific event across different risk categories in the risk profile.
It is particularly useful in assessing not only root causes, but also possible outcomes, and provides a basis for debate regarding key controls which could be implemented. Bow-tie analysis is also a simple and effective tool for communicating risk assessment results to employees at all levels.
The main objectives of the tool is to help evaluate whether the existing controls are effective in meeting the organizations target risk appetite for the specific climate scenario.
The outputs of any bow-tie process should be assessed against the overarching risk appetite of an organisation. For example, while an event could cause negative consequences for a business, it may be that controls are either too expensive or the residual risk level is deemed small enough, that ‘no action’ is deemed to be the best approach. Above all, the bow-tie acts as a tool for debating the best approach, rather than necessarily providing a miracle answer.
Design Risk Mitigation Strategies
Developing risk mitigation plans and improving the control environment is critical and organizations need to align them with stakeholder expectations and then align them with their strategic objectives, core operations and processes.
As shown in Figure 6.5 organizations seek to evaluate and develop risk mitigation plans that need to:
1. reduce the impact and/or likelihood of the climate scenario of concern; and
2. ensure the benefit of the cost of implementation of the control improvement is greater than the cost.
The risk mitigation plans should be formalised as part of ongoing climate change plans as discussed in Chapter 2 in line with risk appetite strategy.
Conclusion
Organizations are increasingly hard-pressed to remain agile in today’s environment and need to understand both their current and possible future risk exposures, including the influence of climate change. It is increasingly important to anticipate key events from emerging trends, constantly adapting to change, and rapidly bounce back from adversity.
It is important to firstly understand the context of what is meant by resilience and to consider what existing or new risk mitigation plans can be designed to help organisations improve their resilience to climate change management processes and how these can be used to help organisations.
It is clear that management need to prepare better for global systemic events and have fully prepared agile contingency plans in place for such events. To do this ERM must act analogous to a football team and play more as an attacking midfield supporting the front line in passing on information in order for the front line to make better decisions.
Businesses ultimately need to understand their exposure to climate conditions and translate these to specific scenarios that can have an impact on the business from an operational, financial or strategic perspective. It is important to consider the range of scenarios and articulate them.
As companies deal with physical changes and a transition to a more sustainable business, they need to align the impacts of climate change to balance sheet solutions that can reduce volatility. Climate change requires a forward-looking approach and the assessment of the ‘more intangible’ transition risks.
This chapter has highlighted the need for Risk management to be more fully integrated into the DNA of the business elevated as a critical process that supports both strategy and financial planning.
i www.aon.com. (2021). 2021 Weather, Climate and Catastrophe Insight | Aon. [online] Available at: https://www.aon.com/weather-climate-catastrophe/index.html. ii Sustainable development: disaster risk reduction. (2016). [online] Available at: https://www.preventionweb.net/files/50683_oiewgreportenglish.pdf. iv Treliant. (2022). Operational and Technological Resilience. [online] Available at: https://www.treliant.com/knowledge-center/operational-and-technological-resilience/ [Accessed 15 Jun. 2022]