Virtually no business will go untouched by the extreme weather events increasing across the world, ... [+]
By Carles Vergara (IESE Business School)
With a new season of wildfires getting underway in the Northern Hemisphere, it’s time to think about whether your company has factored climate risk into its business model.
Virtually no business will go untouched by the extreme weather events increasing across the world. Wildfire season is lasting longer than ever – not just in the U.S., but in places such as Chile, Australia and Spain as well. There’s also the growing risk of floods in cities like New York, Shanghai and Kolkata. Not to mention hotter summers, colder winters and stronger hurricanes and cyclones.
The real estate market, the focus of much of my research, brings home the potentially severe impact of extreme weather events. In one project, carried out with colleagues from the Haas School of Business at the University of California Berkley, we looked at how wildfire losses affected housing and mortgage markets and found that the increasing frequency of wildfires in California leads to higher insurance premiums – simply because the state is considered “at-risk.”
Our findings challenge insurance companies’ ability to absorb losses without serious reconsideration of property and casualty insurance pricing. As a result, one of our biggest takeaways is that companies – now more than ever – need to adapt their business approach to include climate-change-related costs and exposure.
It’s crucial that companies stop treating these events as rare and start considering them in their business decisions – otherwise, they run the risk of facing negative consequences. One example is Pacific Gas and Electric (PG&E), which filed for bankruptcy after being held responsible for faulty electrical lines that caused a wildfire in California in 2018.
4 steps to assess climate-related risk
Here are four steps for business leaders to take to prepare for the risks of climate change:
1. Assess risk exposure with a broad perspective
While nearly every industry will be affected by climate change, not every company will be affected to the same degree. There are several factors to keep in mind, including location. Cities or countries that are more prone to extreme weather will be considered less desirable places to live and work in the near future, affecting economic activity there.
There are also direct and indirect impacts – both of which are important to consider when assessing climate-related risk exposure. When thinking about competitive advantages and investment decisions, it’s crucial to anticipate how competitors may respond to these risks.
2. Reconfigure strategies and business models
Once you’ve properly assessed the kinds of climate-related risks your company may be exposed to, you need to take action. The first step is to factor these risks into your business strategy so that it can guide your decision-making. Many business leaders do so by gathering data to be incorporated into their business models and, after implementing the necessary changes, identifying new opportunities and avenues for growth.
Some examples include changing the locations of your company’s activities – especially if they are considered at high risk of extreme weather – or upgrading your company’s buildings to be more energy efficient. Green buildings made of materials and designs that are better apt for increasingly hot temperatures offer cost savings on utility bills and have a higher property value for developers.
3. Make reasonable changes to mitigate climate risk
Our research found that – as one would expect – the rates of mortgage delinquency and foreclosure increase after a wildfire. However, we were surprised to find that the larger the fire, the lower the level of default and foreclosure. That’s because, instead of moving away from the affected area, homeowners rebuilt their homes under stricter codes demanded by updated insurance coverage. Those renovations significantly increased the houses’ market value.
Our findings highlight the benefits of making reasonable changes to account for climate risk – the sooner you do it, the more likely you are to benefit from it. However, investing in the same spot is not always the most sustainable solution; it’s also important to know when it’s time to move on. One question business leaders can ask themselves is whether climate-risk trends are improving or deteriorating in their area.
4. Consider long-term repercussions
As the frequency of extreme weather events increase, home insurance premiums will get more expensive. This could put a strain on the most vulnerable homeowners, widening the wealth gap that’s already in place. In some cases, insurance will become so costly that the insurers themselves will be unwilling to provide their services. And if a property isn’t insured, it’s nearly impossible to take out a mortgage – therefore having a big impact on mortgage markets and housing prices.
In fact, one of the key building blocks of the real estate world – the 30-year mortgage – is in danger of being lost in high-risk areas. Because climate change is affecting severe weather at an unprecedented speed, lenders can’t estimate the impact of climate risk over such a long timeline and insurers are not willing to provide protection. Therefore, it’s essential to have a viable market for flood and fire insurance – or else risk having areas with nonexistent housing markets.
Carles Vergara is a professor in the Financial Management Department of IESE Business School. More on his research on business and climate change can be found on IESE Insight.
