The United States was hit by two major hurricanes a week apart recently, and in addition to the extreme devastation to people’s homes and lives, the storm’s impacts on businesses have, in many cases, been catastrophic.
On Thursday, an article in the Harvard Business Review (HBR) discussed the need for businesses, big and small, to disclose information about their exposures to climate-related risks, including the company’s relationship between financial variables and climate change impacts.
With climate change and its extreme weather events becoming more common, businesses need to prepare climate-related financial disclosures that would help investors and other stakeholders in understanding material risks, focusing on four key elements: corporate governance, strategy, risk management, and climate-related metrics and targets.
Weather-related impacts on business
Research has shown that extreme weather events disrupt the operating and financial performance of 70 percent of companies worldwide. We are seeing weather events lasting from weeks to months or even longer. These events cause shortfalls in sales and reduced cash-flow, leading to possible financial distress or business failure.
As the HBR points out, every year, weather disruptions are estimated to cost $630 billion for the U.S. alone, or 3.5 percent of the GDP. But even this number doesn’t really give us an accurate accounting of the true extent of the harm to individual businesses such as utilities, retail, food processing, transportation, and construction, among other industries.
Keep in mind that weather events affect consumers, too. As an example, the apparel industry was impacted because of the unusually warm winter temperatures across Europe and the U.S. last year. This resulted in lower sales, job cuts, and store closures.
And based on the number of store closings or businesses restructuring, the impacts are still going on. As a matter of fact, fully two-thirds of business managers say they have been negatively affected by weather over the last three years. Customers and staff, and logistics, including supply chain, utilities, and transport are the most frequently occurring problems for small businesses during severe weather events.
Weather-based financial instruments
To be realistic, financial losses caused by unusual weather events 20 or 30 years ago were not given the scrutiny they deserved. However, they must be closely monitored and managed with weather-based financial instruments. The instruments have been around since 1997 and have been used by utility companies to compensate investors for financial losses when the weather index exceeds a predefined level.
These weather-based financial instruments work like any other hedging instruments, except they are weather-related and take into account average temperature thresholds, rainfall levels, wind speeds or any combination of variables that represent the risk to which the business is exposed.
Regardless of which hedge instruments are used, for a business to have an effective risk management framework, the risks have to be defined. And this needs to be in writing — Including the relationship between financial variables such as sales, volume, profits or margins and a weather index.
Up until recently, there has been very little access to the sort of reliable historical weather data needed for an individual business to model their exposure to weather-related risks. Today, big data and cloud computing have made it possible to store and manage vast amounts of weather data required to evaluate weather risks in any part of the world.
Transparency in disclosure of weather-related risks
Weather-related risk management is still in its infancy, and most small companies have no real idea of just how much of their business may be at risk. Most accounting standards don’t even list weather events to which a sensitivity analysis must be provided to investors. This is why the Task Force on Climate-related Disclosures (TFCD) released the new Climate-Related Financial Disclosure Framework in July.
Being transparent and reporting on clear, comparable and consistent information about the risks presented by climate change has been voluntary, however, to better protect investors and other stakeholders, it has become essential that companies take weather-related risks into consideration when making financial decisions.
