Impact of climate-related risks on the balance sheet

Climate-related risks refer to the potential negative impacts of climate change on an organisation.

There are two categories of climate-related risks. The first category is physical risks, which arise from the changes in weather and climate. Some examples of physical risks include acute droughts, floods, precipitation, wildfires and the effects of rising temperatures and loss of biodiversity.

The second category is transition risks, which arise from the transition to a low carbon economy. They include technological, market, reputational, legal, and regulatory risks.

Though many organisations have made net-zero pledges and transition commitments to manage these risks and take advantage of opportunities, the war in Ukraine will have an immediate and short-term impact on the timelines for net-zero pledges and decarbonisation efforts globally as more fossil fuel is pumped to deal with the unfolding global energy crisis.

However, some share the view that the duration and contained scope of the war will have a medium to long term effect on net-zero transition timelines and programs globally.

Both physical and transition climate-related risks could impact an organisation’s balance sheet (assets and liabilities) and business activities in the short, medium, and long term.

Impact assessment

Organisations should begin to perform impact assessments on the effects of climate-related risks on their balance sheets. It should form part of the response by an organisation to the overall risks posed by climate change to the organisation and society at large.

The use of climate scenario analysis, a process that identifies a range of scenarios that provide a variety of possible future climate conditions and the impact and response of the organisation, is a welcome addition to this assessment.

These assessments will enable the organisation to understand the effect of climate-related risks on specific assets and liabilities of the organisation.

Organisations would also understand the immediate and long-term effects of these climate-related risks on their business activities and performance.

For instance, organisations may identify stranded assets that do not earn the organisation an economic return due to changes associated with the transition to a low-carbon operation before the end of the asset's economic or useful life. Organisations across an economy contribute emissions that affect climate change directly or indirectly.

However, some aspects of the economy create significant emissions like power, mobility (road, aviation, rail, maritime), agriculture, forestry, waste (disposal, incineration, and treatment), buildings (heating and cooking) and industry (steel, cement, chemical and extraction and refining of minerals).

Therefore, understanding the position of an organisation and the scope of its emissions through an impact assessment will enable the organisation to plan adequately for its future, long term competitiveness and sustainable growth.

Balance sheet review

Some of the balances organisations should consider on the balance sheet include impairment assessment for investments held in a subsidiary, joint venture and associate companies making allowance for the effect of climate-related risks on forecast assumptions such as growth and cash flows.

The recoverability of receivables and loans that carry significant exposure to climate-related risks could affect the value of such assets and the credit risk measurement. Organisations should also ensure that they maintain adequate provisions to cover decommissioning obligations related to the retirement of assets.

The useful lives and residual values of intangible assets, property, plants, and equipment held by organisations would have to be reviewed and possibly revised for the impact of climate-related risks.

Insurance companies, for instance, would have to consider the increased frequency and magnitude of insured events together with an accelerated timing of the occurrence of an insured event on the measurement of its insurance liabilities as a result of climate-related risks.

Awodumila is an Associate Director at PwC Kenya. An author who writes and speaks widely on corporate reporting topics