Physical Risks and Adaptation: An Analysis of Regulatory Requirements

Introduction

Physical Risks Associated with Climate Change, and, more generally, the issue of adapting to climate change, are gaining prominence in the economic and financial world. The distinction between physical risks and transition risks is now well established, and the fight against climate change is being waged on two fronts: reducing greenhouse gas emissions and building resilience to climate impacts. The level of maturity among economic actors in this second area (climate resilience) lags significantly behind that in the first area (emissions mitigation). However, renewed interest has been evident in recent months.

This trend can be explained by the increasing number of visible impacts of climate change on economic activities, but not solely by that. Regulatory and voluntary reporting frameworks, which are becoming increasingly stringent with regard to physical risks, are a major factor in the interest organizations are showing in this topic. These frameworks therefore appear to be essential for engaging economic actors in efforts to build resilience and adapt to climate change.

Several regulatory and voluntary frameworks exist, but are their requirements regarding physical risks aligned? And do they adequately address the challenges of resilience and adaptation to climate change?

In this article, we present a comparative analysis of the compliance criteria related to resilience and adaptation in the four main reporting frameworks for organizations: the Task Force on Climate-Related Financial Disclosures (TCFD)^[1], the Carbon Disclosure Project (CDP)^[2], the European Taxonomy^[3] and the Corporate Sustainability Reporting Directive (CSRD)^[4].

Description of Reporting Frameworks

Published before any regulations were in place, The TCFD report published in 2017 was the first set of guidelines for companies wishing to communicate how they are addressing the physical risks associated with climate change. This report was subsequently refined and supplemented by other publications and the CDP drew on the work of the TCFD to supplement his initial list of questions—which focused on the transition—with questions about physical risks. In 2020, the European Taxonomy Regulation established, for the first time through regulation, how European companies should address climate change adaptation^[5]. The CSRD is a European directive that replaces the NFRD, which will take effect gradually starting on January 2024. This directive applies to European companies and builds upon the Taxonomy, supplementing it to make the disclosure of information related to climate change—and in particular, adaptation to physical risks—mandatory. The CSRD is based on standards known as “ESRS” standards (European Sustainability Reporting Standards), which are prepared by theEFRAG (Advisory Group on Financial Reporting in Europe.

Key Principles and Best Practices for a Climate Change Adaptation Approach

At Carbone 4, we believe that an ambitious approach to climate change adaptation must meet the following criteria.

Risk Assessment

• Risk Analysis covers all the processes on which the organization depends^[6], to identify all sources of risk to the company's operations (see OCARA^[7](for the concept of scope of analysis)
• Risk assessment takes into account the three components of climate risk, namely a component Aléa, a component Vulnerability and a component Exhibition

• The risk assessment takes into account existing adaptive capacities, in order to calculate the net (or residual) risk

• The risk analysis has been completed according to several climate scenarios, in order to test the sensitivity of the system under study to global warming, manage the inevitable, and avoid the unmanageable (for more information, read our recommendations for use SSP (Shared Socio-economic Pathways) scenarios^[8] (as part of a climate change adaptation strategy).
• The risk analysis has been completed for severaltime horizons, in order to plan the necessary short-term and long-term actions, taking into account the lifespan of the objects under study.
• The risk analysis covers all contingencies to which at least one critical process on which the organization depends is vulnerable. Thus, conducting a vulnerability analysis on a large number of hazards as a first step—as we recommend in the OCARA guide—enables the organization to identify which hazards require in-depth analysis and regular monitoring.
• Risk Analysis can provide quantitative estimates of economic impacts if climate risks materialize, in order to illustrate the severity of the identified risks and compare them to the cost of the preventive measures to be implemented.
• The analysis helps identify any climate opportunities.

Adaptation Plan

• The organization is implementing an adaptation plan, meaning that it has identified additional adaptation measures it can implement to increase its climate resilience, and that it has developed a plan for these actions by prioritizing and sequencing them over time.

Comparative Analysis

We conducted a detailed review of the main physical risk reporting frameworks. This assessment allowed us to highlight the key differences between these frameworks and to facilitate an understanding of the specific characteristics of each.

We identify two categories of criteria for compliance with reporting frameworks:

• The first category concerns the scope of what organizations are required to report. The criteria are as follows:
  • The organization must conduct and report on an analysis of the physical risks associated with climate change that covers all the processes on which the organization depends
  • The organization must establish and report on a adaptation plan to climate change
  • The organization must provide quantitative estimates of economic impacts if climate-related risks were to materialize
  • The organization must conduct and report on a analysis of climate-related opportunities
• The second category concerns the technical characteristics of the risk analysis that the organization must conduct. The criteria are as follows:
  • The physical risk analysis must be conducted based on a predefined list of hazards
  • Risk analysis must take into account the three components of risk: hazard, vulnerability, and exposure
  • Existing adaptive capacities are factored into the risk assessment to determine the net risk
  • The risk analysis must be conducted based on several global warming scenarios
  • Risk analysis must be conducted for several time horizons

The following table summarizes, for each of the frameworks examined, whether or not each compliance criterion in the first category is present. Some frameworks do not mention these criteria (we indicate this as “no”), some mention them very clearly (“yes”), and others imply them but are not explicit on the subject (“ambiguous”).

The following table summarizes, for each of the frameworks examined, whether or not each compliance criterion in the second category is present. The legend has the same meaning as in the previous table.

A review of the reporting frameworks, including the references cited in the methodological guides, reveals that the vast majority of the analysis criteria are included.

Still, a few differences stand out:

• European Taxonomyappears to be the least detailed and demanding framework, because it does not explicitly require an analysis of the risks associated with all the processes on which the organization depends, nor does it require quantitative estimates of economic impacts. Furthermore, the technical specifications required for certain risk analysis criteria are ambiguous.
• The CDP and the CSRD do not require the reporting of net risk.
• The CDP is the only framework that does not mention the three components of climate risk.
• The TCFD ultimately stands out as one of the most rigorous disclosure frameworks for physical climate risks.

Conclusion

Reporting frameworks related to physical risks and adaptation are not easy to grasp. A certain level of prior expertise is necessary to fully understand the reporting requirements and what they entail in terms of analysis.

That said, after a detailed analysis of the texts, it appears that The requirements of the reporting frameworks are generally aligned and tailored to ensure a proper understanding of climate risks. This regulatory environment is therefore favorable to engage economic stakeholders in efforts to adapt to climate change.

It might be helpful to assist stakeholders in fully understanding these frameworks; we hope this explanatory note will help them do so!

Appendices

The tables from the benchmark study of the main frameworks for analyzing physical risks are presented below, along with additional information and details that were not included in the main body of the article.