If you need a good scare, take a look at this study on climate risk from consultant McKinsey.  The study was the result of a year’s effort to measure the potential socioeconomic impact of climate change. As the risk of acute and chronic hazards intensifies, McKinsey assessed physical risk, looking at nine examples to illustrate the potential impact. Could this study focusing on socioeconomic impact have been one of factors driving BlackRock CEO Laurence Fink to put sustainability at the center of BlackRock’s investment strategy? (See this PubCo post.) According to the WSJ, “[c]limate crises in the next 30 years may resemble financial crises in recent decades: potentially quite destructive, largely unpredictable and, given the powerful underlying causes, inevitable. Climate has muscled to the top of business worries….Yet worrying about it isn’t the same as doing something about it.”  McKinsey suggests that climate change will “need to feature as a major factor in decisions. For companies, this will mean taking climate considerations into account when looking at capital allocation, development of products or services, and supply chain management, among others.” As the study asks, “could climate become the weak link in your supply chain?” The study makes plain that companies will need to think carefully about climate risk and its “knock-on effects” in considering, planning for and describing for investors the risks of their businesses. McKinsey also provides some questions for companies to consider in that regard.

According to McKinsey, the temperature of the planet “has risen by about 1.1 degrees Celsius on average since the 1880s,” and the rate of warming is “at least an order of magnitude faster than any found in the past 65 million years of paleoclimate records.”  What’s more, a small change in the average “conceals more dramatic changes at the extremes.”

McKinsey found that “the level of physical climate risk increases by 2030 and further by 2050. Across our cases, we find increases in socioeconomic impact of between roughly two and 20 times by 2050 versus today’s levels.” As warming continues, the socioeconomic impact will increase “in a nonlinear way as hazards reach thresholds beyond which the affected physiological, human-made, or ecological systems work less well or break down and stop working altogether. This is because such systems have evolved or been optimized over time for historical climates.”

Although the direct impact may be local, “it can have knock-on effects across regions and sectors, through interconnected socioeconomic and financial systems.” For example, while projected flooding in Florida could damage housing locally, it could also “raise insurance costs, affect property values of exposed homes, and in turn reduce property tax revenues.” Similarly, infrastructure could be destroyed or disrupted by hazards including heat, wind or flooding, leading to a decline in the services or a rise in the cost, with knock-on effects on other sectors that rely on these infrastructure assets.

McKinsey’s key findings included:

  • “Economic and financial systems have been designed and optimized for a certain level of risk and increasing hazards may mean that such systems are vulnerable when they reach systemic thresholds. For example, rising climate hazards could affect regional “breadbasket” areas that account for about 60% of global grain production, potentially causing them to fail if key production hubs are affected. In addition, supply chains are often designed for efficiency over resiliency, by concentrating production in certain locations and maintaining low inventory levels.” 

For example, McKinsey assessed the potential impact of climate change on supply chains, focusing on two global supply chains—semiconductors and heavy rare earth metals, a commodity critical to many electronic devices:

“For semiconductors, the probability of an event with the magnitude of what is today a 1-in-100‑year hurricane, with the potential to disrupt semiconductor manufacturing, occurring in any given year in the western Pacific, is projected to double or even quadruple by 2040. In this scenario, such hurricanes could potentially lead to months of lost production for the directly affected companies. For unprepared downstream players, for example, those without buffer inventories, insurance, or the ability to find alternate suppliers, the revenue loss in a disaster year could be as high as 35 percent, according to our estimates. For heavy rare earths, which are mined in southeastern China, the likelihood of extreme rainfall in the region sufficient to trigger mine and road closures is projected to rise from about 2.5 percent per year today to about 4 percent per year in 2030 and 6 percent in 2050. Given the commoditized nature of this supply chain, impacts on production could result in increased prices for all downstream players.”

  • “Societies and systems most at risk are ones already close to physical and biological thresholds.” For example, McKinsey estimates that, by 2030 (only 10 years away) under an RCP 8.5 scenario (a relatively higher greenhouse gas-emission scenario that assumes no decarbonization), “between 160 million and 200 million people could live in regions with a 5 percent average annual probability of experiencing a heat wave that exceeds the survivability threshold for a healthy human being, absent an adaptation response.” The heat is also expected to affect outdoor labor productivity, reducing the effective number of hours that can be worked outdoors and, by 2030, putting at risk up to 4.5% of annual GDP.
  • Finance and insurance are also vulnerable if the level of risk for which they were designed is exceeded by intensifying climate hazards. As a result, financial markets “could bring forward risk recognition in affected regions, with consequences for capital allocation and insurance cost and availability. Risk recognition could trigger capital reallocation and asset repricing and indicates the presence of systemic risk.”
  • “Large knock-on impacts can occur when thresholds are breached. These systemic risks come about in particular when the people and assets affected are central to local economies and those local economies are tied into other economic and financial systems.” For example, in Ho Chi Minh City,  infrastructure asset damage from a 100-year flood could have knock-on costs to the economy at levels rising to between $2 billion and $8.5 billion.
  • “Climate change could create inequality—simultaneously benefiting some regions while hurting others.” Typically, the poorest communities and populations are the most vulnerable to climate events, often lacking financial resources or outside support to aid in recovery.

Questions for companies

McKinsey developed the questions below for companies outside the financial sector to consider:

“— What opportunities exist to convene the industry around physical risk, including by building knowledge that is sector- and region-specific?

— How could we incorporate a structured risk-management process that enables good decision making and integrates an assessment of physical and transition climate risk into core business decisions (for example, sourcing, capital planning, and allocation decisions)?

— How might climate change affect core production (risk of disruption or interruption of production, increased cost of production factors); sourcing and distribution (risk of disruption of the upstream supply chain or the downstream distribution, delaying or preventing inflow of inputs and distribution of goods, increasing costs or reducing product prices); financing and risk management (risk of reduced availability or increased cost of financing, insurance, and hedging); and franchise value (risk of declining value of investments and goodwill, disruption of right to operate or legal liabilities)? What business model shifts will be needed?

— How big and urgent are the most relevant climate change risks and what countermeasures should be taken to adapt to and manage them, based on risk appetite (for instance, if risks to sourcing of inputs have been recognized, identifying alternate suppliers or raising inventory levels to create backup stock; or if climate exposure is expected to drive market shifts or impact terminal value of assets, reallocating growth investment portfolio)?”

Posted by Cydney Posner