Quantifying the financial cost of climate change: three challenges to overcome

From getting a full view of climate risk to generating meaningful insight that businesses can use to build resilience, WTW’s climate practice head Peter Carter looks at the climate risk quantification obstacles that need to be overcome.

Precisely quantifying climate risk is essential to comply with evolving climate reporting requirements. More importantly, it is critical to making informed decisions towards building resilience in a warming world that’s transitioning to a lower-carbon economy.

However, many organisations will face obstacles in securing robust climate risk quantification insights to help them manage climate risk effectively and drive long-term success. There are perhaps three standout climate risk quantification challenges that cannot be overlooked.

Challenge one: Carbon emissions do not provide the full picture

While quantifying carbon emissions is important in terms of meeting certain climate disclosure requirements, this will not provide a comprehensive view of climate risk.

A 2023 joint report from WTW and the Institute of International Finance highlights how emissions quantification tends to be backward-looking and therefore may not accurately capture how the profitability of a business is likely to be affected into the future. There’s also a low correlation between financial risk and carbon intensity.

This means an organisation needs to find additional climate risk quantification techniques. These methods should be capable of measuring the consequences of physical climate change on a company’s assets and the secondary effects resulting from changes in business models and supply chains as they adapt to a lower-carbon economy. This kind of approach will help to reach a better understanding of the financial impacts of climate risks.

If we think about managing climate transition risks – and opportunities – these relate to the business uncertainties around net-zero transition, such as policy, legal and market changes. These shifts could see some organisations face significant moves in asset values, cashflows and higher costs of doing business. Analytical techniques can let you quantify transition risk as a financial impact.

Using this type of approach, you can define transition risk as the difference in future value between a business-as-usual scenario and a given number of transition scenarios. You can then feed these outputs into your transition plan disclosures and, more crucially, into strategic decision-making more likely to support resilience and growth.

Challenge two: Quantifying climate risk beyond tick-box disclosure

Quantifying climate risk takes time and effort. In terms of efficiency, it’s better if your climate reporting outputs are useful for more than simply ticking climate reporting boxes. Ideally, you need information that not only guides your ability to meet climate and sustainability commitments but also ensures capital is allocated in the right places to protect against climate-driven uncertainty and volatility.

Once you use techniques that let you measure the financial impact of your specific physical and transition risks, you can better justify the need for proactive measures and achieve a stronger return on investment.

Analytical modelling can also enable you to explore multiple scenarios, pressure test your assumptions around strategic decisions, anticipate and respond to changing risks, then adapt your strategies accordingly. When robust climate analytics is embedded in your organisation, you can improve your risk transfer and adaptation strategy to reduce your physical risks and make business decisions more likely to outperform your peers in the transition.

This proactive climate risk quantification approach can support your climate reporting requirements while generating the insight you need to inform resilience against physical or transition risk related events or losses.

Challenge three: Qualitative methods lack precision

Climate risks are complex and inter-related. It’s understandable why your organisation may turn to more traditional qualitative methods, such as scenario analysis workshops, to provide a high-level understanding of potential future outcomes.

However, these processes are resource-intensive and rely on being able to get business leaders together regularly to build consensus on identifying and quantifying the risks the business needs to prioritise. Overall, the process may also lack the precision and repeatability necessary for effective climate risk governance.

Dynamic physical and transition risk models and algorithms provide a more objective, repeatable and auditable approach to climate risk quantification. These models allow you to create a perspective you can track through time, verifying the assumptions and causality behind the insight you generate.

These perspectives can complement climate risk governance forums like senior stakeholder workshops or risk committees, enabling the business to validate and test climate risk management strategies.

With robust, repeatable and transparent climate risk quantification, it’s easier to demonstrate to auditors or compliance officers how the business arrived at key decisions and be confident you’re allocating resources in optimal ways to support resilience and growth in the face of complex climate risks.

Dynamic climate risk quantification models can also give decision-makers real-time feedback on the financial impacts of complex changes resulting from climate risks. This feedback helps prioritise actions and focus on acute problems that could challenge the viability of operations in the future.

By having tools you can engage with frequently over a year, or even over a decade, you can explore the changing landscape as part of a continuous process, generating auditable feedback on what's driving your progress to reaching a climate-resilient future.

Peter Carter is head of climate practice and head of captive and insurance management solutions at WTW