CHAPTER 1
Introduction: Why We Need a Risk Taxonomy

The year 2022 has been another year of major economic upheaval due to the continued escalation of climate change (mainly global heating) impacts, most noticeably as natural catastrophes. The catalog of physical risks on display is considerable. Numerous droughts either continued or emerged: in the American Southwest there has been a record heatwave (over the past twenty years); a drought in China; a record drought in Chile; and a Northern European drought so severe that water levels in the Rhine dropped so much that river traffic, a critical element in Germany's export-dependent economy, was essentially blocked for several weeks. Water levels in rivers worldwide dropped to record or near-record levels, including in the western United States and China, and even the River Po in Italy and other areas in Europe.

Not to be outdone as a disaster category, record flooding in Pakistan, India, and Nigeria displaced tens of millions, produced significant amounts of topsoil loss and land destruction, and impaired crop production in many countries dependent on agricultural exports (not to mention serving domestic agricultural needs). In addition, significant flooding in Australia (again), parts of Brazil, and portions of the eastern United States (again) had significant negative economic impacts. Flooding associated with Hurricane Ian has proved to be Florida's largest economic disaster ever. The increase in flooding in Africa is particularly worrisome given the still-high dependence on local agricultural resources in many countries. The increased severity of extreme weather events is another concerning phenomenon. Japan, the Philippines, and Pakistan were each the victims of record or near-record-intensity storms over the course of the year.

At several points during the first nine months of the year there were so many simultaneous major extreme weather events around the world that one had to check to make sure whether one was reading about an existing disaster, or a new one. But extreme weather is simply the most obvious manifestation of the potential impacts of global heating.1 Other less dramatic, but perhaps more significant, events and processes continued unabated. Glacial melt in both Greenland and Antarctica accelerated in both regions-these are the largest glacial areas in the world, and ice continues to disappear (turning into either water or water vapor) in both regions, with potentially major impacts on the earth's air and water circulation systems. Deforestation in critical forested areas-the Amazon, Africa, Southeast Asia, and northern areas such as Russia, Alaska, and Canada-continues through human activity, but also increased wildfires. Multiple places were subject to extremely hot temperatures, particularly India, Bangladesh and Pakistan, but also western China, which saw its worst heatwave in recorded history.

The human costs are, in terms of land displacement alone, significant, and will likely continue to rise. The current century is expected to be one of increased global migration on the back of environmental, usually climate-related, events and processes that will make portions of the planet increasingly unlivable for humans. Political and social conflicts relating to potential resource availability and scarcity issues are expected to increase. There is already evidence of intensifying competition for water resources in a number of places around the world, for example. The current rate of topsoil depletion suggests that topsoil could become another area of concern over scarcity. Climate impacts are expected to intensify competition for increasingly scarce natural resources.

Moreover, in October 2022 the United Nations Framework Convention on Climate Change (UNFCCC) issued a synthesis report indicating that signatories to the 2015 Paris Agreement are lagging considerably in meeting their climate commitments.2 As noted in the report,

The best estimate of peak temperature in the twenty-first century (projected mostly for 2100 when temperature continues to rise) is in the range of 2.1-2.9 °C depending on the underlying assumptions.

This is, of course, considerably higher than the 1.5 °C target agreed to in the 2015 Paris Climate Agreement, mainly because most signatories have not been meeting proposed Nationally Indicated Commitments. We are losing ground, in other words.

Thus far 2022 has also highlighted another disturbing trend, particularly for investors and lenders-the negative impacts of global heating are costing more than they did ten years ago. The impacts here are broad-based, ranging from individual homeowners to municipalities to state and national governments and, of course, businesses of all size, and their insurers. The US National Oceanic and Atmospheric Administration (NOAA) has noted that for the United States alone the number of "billion-dollar natural disasters" through nine months of 2022 is running well above its historical average, and in fact appears to parallel years of all-time highs (although as NOAA points out, the financial impact has been below 2021, and the record year of 2017). The trend for this is shown in Figure 1.1.

FIGURE 1.1 United States' billion-dollar disaster event count.

Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, 2022.

As Figure 1.2 shows, the range of disasters is relatively broad, encompassing extreme weather, drought, and flooding in particular.3

On a global basis the narrative is fundamentally similar. As Swiss Re has noted,4

The rise in insured losses maintained a long-term trend (based on 10-year moving averages) of 5-7% growth annually. Once again, secondary perils, including floods, were at the forefront, accounting for more than 70% of all insured losses. It was the first year ever that two separate secondary perils events-winter storm Uri in the US and the flood in western/central Europe in July-each caused losses in excess of USD 10 billion.

The impacts of these events, most of which are flood related, are socially and economically very broad-based, and in some parts of the world potentially catastrophic in terms of, for example, topsoil lost in excessive flooding.5 For investors and lenders, the impacts will not be nearly as draconian. Nonetheless, there is a broad spectrum of potential financial impacts that may range from asset value destruction to revenue and profitability losses, reduced tax revenues for governments, and higher insurance losses and costs.

FIGURE 1.2 United States' 2022 billion-dollar weather and climate disasters.

Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, 2022.

For a number of observers, then, these developments have more than a passing import. Investors, lenders, and financial regulators are paying increasing attention to these potential costs, and to the risks underlying them. Unsurprisingly, this is largely because it has become clear that these costs will continue to rise as the impacts of global heating continue to grow. This has resulted in multiple initiatives to try to capture and organize the factors driving these costs, of which the Task Force on Climate-related Financial Disclosures (TCFD) is probably the best-known example.6 (We will discuss these recommendations, and others, in more detail in Chapter 2.) This has also led to considerable work on cataloging those areas where investors and lenders can help facilitate a transition from our currently carbon-dependent economy to an energy system considerably less reliant on carbon energy sources, particularly with an overall target of reducing Greenhouse Gas (GHG) generation by firms and sovereign entities. The EU's Sustainability Taxonomy is perhaps the best-known example of this.7 We note that much of this work has taken the form of more detailed and robust tracking of GHG emissions.

However, as we hope to make clear in this book, climate risk identification, assessment, and reporting may encompass a substantially broader landscape than simple reporting of GHG generation on an annual basis. For investors and lenders, climate change represents a medium- to long-term trend with the potential to have wide-ranging financial impacts on companies in a range of potentially affected industries, including on their credit profiles and/or share prices-or, indeed, their continued going-concern status. However, this knowledge is not necessarily helpful for lenders, investors, or regulators unless these potential risks can be granulated and quantified in terms of their scope and, more importantly, their timing and likelihood. A sufficient granulation of the potential risks being discussed here, along with some assessment of likelihood and timing of potential impacts, will facilitate an assessment of their specific financial manifestations, be it cash flows, asset valuations, margin impacts, or credit ratios, for example.

Moreover, increased concern among lenders, investors, and regulators over potential climate risks and some of the uncertainties associated with these risks has highlighted the need for a more rigorous assessment of just what those risks actually are.8 This concern is being driven by two factors:

1. the increased frequency and...