Understanding Climate Risk VaR

Introduction

Climate change poses significant risks to global economies, and the Middle East is no exception. This region, characterized by its arid climate and economic dependence on oil and gas, faces unique challenges as the planet warms. Climate Risk Value at Risk (VaR) is a critical metric for assessing the potential financial losses due to climate-related risks. This article explores Climate Risk VaR with a focus on examples from the Middle East, highlighting the importance of this measure for businesses, investors, and policymakers in the region.

Climate Risk VaR Explained

Climate Risk VaR is a quantitative measure used to estimate the potential financial losses a company, asset, or portfolio might incur due to climate-related risks. These risks are categorized into three main types:

1. Physical Risks: Direct impacts of climate change, such as extreme weather events, rising temperatures, and sea level rise.
2. Transition Risks: Economic and financial risks associated with the transition to a low-carbon economy, including regulatory changes, market shifts, and technological advancements.
3. Litigation and Reputational Risks: Legal challenges and damage to a company's reputation resulting from perceived inadequate action on climate change.

Global Climate Risk Data

1. Physical Risks: Extreme Weather Events: According to Munich Re, global losses from natural disasters in 2022 totaled approximately $270 billion, with climate-related events such as storms and floods being significant contributors. Rising Temperatures: The World Meteorological Organization reported that the last eight years have been the warmest on record, with 2022 being around 1.15°C above pre-industrial levels. Sea Level Rise: The Intergovernmental Panel on Climate Change (IPCC) projects that global mean sea levels could rise by 0.29 to 1.1 meters by 2100, depending on emission scenarios.
2. Transition Risks: Regulatory Changes: The International Energy Agency (IEA) noted that over 120 countries have announced net-zero targets by mid-century, influencing regulations and market dynamics. Market Shifts: The global renewable energy market is expected to grow from $881.7 billion in 2020 to $1,977.6 billion by 2030, reflecting a compound annual growth rate (CAGR) of 8.4%.
3. Litigation and Reputational Risks: Litigation: There have been over 1,800 climate-related lawsuits filed globally as of 2022, with a significant increase in cases targeting corporations for their role in climate change. Reputational Risks: Companies failing to address climate risks are increasingly facing backlash from investors and consumers, as seen with the rising trend of ESG (Environmental, Social, and Governance) investing.

Middle East Climate Risk Data

1. Physical Risks: Heatwaves: The Middle East has experienced significant temperature increases. For example, Kuwait recorded a temperature of 54°C in 2016, one of the highest on record globally. Water Scarcity: The region is one of the most water-scarce in the world. According to the World Resources Institute, 12 out of the 17 most water-stressed countries are in the Middle East and North Africa (MENA) region. Sea Level Rise: Coastal cities in the Middle East are at risk from rising sea levels. The UAE has invested billions in coastal defenses and desalination projects to mitigate these risks.
2. Transition Risks: Regulatory Changes: The UAE aims to achieve net-zero emissions by 2050, influencing regulatory frameworks and driving investment in renewable energy. Market Shifts: Saudi Arabia’s Vision 2030 aims to diversify its economy away from oil, investing heavily in sectors like tourism, entertainment, and renewable energy. Technological Advancements: The Middle East invests in clean energy technologies, with significant projects like Saudi Arabia’s NEOM city aiming to be powered entirely by renewable energy.
3. Litigation and Reputational Risks: Legal Risks: Qatar faced international scrutiny over its environmental practices before the 2022 FIFA World Cup, highlighting the potential for litigation and regulatory pressure. Reputational Risks: National oil companies like Saudi Aramco are increasingly focusing on sustainability to maintain their global reputation, reflecting broader industry trends.

Calculating Climate Risk VaR

To calculate Climate Risk VaR, companies and investors need to follow several steps:

1. Identify Risks: Recognize the specific climate-related risks that could impact their operations or investments.
2. Scenario Analysis: Develop scenarios considering different levels of global temperature rise and associated impacts. For example, scenarios could include severe heatwaves, regulatory changes, and market shifts towards renewables.
3. Risk Assessment: Quantify the potential financial impact of these risks under each scenario. This involves using historical data, climate models, and expert judgment.
4. Probability Estimation: Estimate the likelihood of different scenarios occurring, based on climate projections and regulatory trends.
5. VaR Calculation: Combine the financial impact and probability estimates to calculate the Value at Risk, usually expressed as a monetary value representing the maximum expected loss over a given time horizon at a specific confidence level (e.g., 95% or 99%).

Example Calculation of Climate Risk VaR

Let's consider a simplified example for a real estate company to understand how Climate Risk VaR is calculated. Suppose the company owns coastal properties valued at $1 billion, which are at risk of flooding due to sea level rise.

1. Identify Risks: The primary risk is flooding due to sea level rise.
2. Scenario Analysis: Develop two scenarios: Scenario A: Moderate sea level rise (0.5 meters), with a 10% probability. Scenario B: Severe sea level rise (1 meter), with a 5% probability.
3. Risk Assessment: Scenario A: Estimated loss of $100 million. Scenario B: Estimated loss of $300 million.
4. Probability Estimation: Given in the scenarios.
5. VaR Calculation: Calculate the expected loss for each scenario and combine them to estimate the VaR at a 95% confidence level.

VaR=(Probability?of?Scenario?A×Loss?in?Scenario?A)+ (Probability?of?Scenario?B×Loss?in?Scenario?B)

VaR = 0.10*100 million + 0.05*300 million

VaR - 10 million + 15 million = 25 million

Thus, the Climate Risk VaR for the real estate company is $25 million, meaning there is a 95% confidence that the company will not lose more than $25 million due to sea level rise.

Applications of Climate Risk VaR

• Investment Decisions: Investors use Climate Risk VaR to assess the potential impact of climate change on their portfolios, informing asset allocation and risk management strategies.
• Risk Management: Companies incorporate Climate Risk VaR into their risk management frameworks to identify, assess, and mitigate climate-related risks.
• Regulatory Compliance: Financial institutions and businesses may be required to disclose their Climate Risk VaR as part of regulatory frameworks and sustainability reporting standards.
• Strategic Planning: Organizations use Climate Risk VaR in their long-term strategic planning to address future challenges and opportunities related to climate change.

Conclusion

Climate Risk VaR is an essential tool for understanding and managing the financial impacts of climate change, particularly in vulnerable regions like the Middle East. By identifying and quantifying the risks associated with physical impacts, the transition to a low-carbon economy, and potential litigation and reputational damage, businesses and investors can make informed decisions to safeguard their assets and ensure sustainable growth. As the Middle East continues to adapt to the realities of climate change, adopting Climate Risk VaR will play a crucial role in navigating this complex landscape.

References

1. Munich Re. (2023). Natural Disasters 2022. Retrieved from Munich Re .
2. World Meteorological Organization. (2023). State of the Global Climate 2022. Retrieved from WMO .
3. Intergovernmental Panel on Climate Change. (2021). Sixth Assessment Report. Retrieved from IPCC .
4. International Energy Agency. (2022). Net Zero by 2050: A Roadmap for the Global Energy Sector. Retrieved from IEA .
5. Allied Market Research. (2022). Renewable Energy Market by Type and End-Use Industry: Global Opportunity Analysis and Industry Forecast, 2020-2030. Retrieved from Allied Market Research .
6. Grantham Research Institute on Climate Change and the Environment. (2022). Global trends in climate change litigation