Summary:
- Among the weather events that can affect value chains, extreme events (floods, storms, droughts) are the most likely to cause damage and losses.
- Sectoral exposure to physical risks can be estimated on the basis of an analysis that takes into account both the properties of the value chain and the geographical location of its components.
- This exposure is based mainly on two angles of analysis: 1) The sectoral angle allows for the categorization of sectors and even the characteristics of their value chains and their interdependence, 2) The geographical angle requires the selection of a grid adapted to the type of event considered.
- The most widely used method for estimating damage related to physical risks is that proposed by the IPCC in 2012, with a three-step approach: hazard, exposure, and vulnerability.
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Extreme weather events such as floods, storms, or droughts pose a significant risk of disruption to business operations, which can lead to increased operating costs, damage to infrastructure, and compromise the financial stability of companies in a sector.
Given the interdependence between sectors, which has been highlighted by the COVID-19 crisis, estimating the future transmission of risk is a considerable challenge, which we will briefly review in this article. We will focus in particular on the transmission of this risk across a value chain.
1) Complexity of value chains: an aggravating factor or a means of diversifying risk?
1.1 Complexity of a value chain
When assessing a company’s exposure to physical risks, a major challenge is locating the components of value chains. This strategic data is rarely available in global databases.
While geographical disparities between regions encourage a narrower focus, the transport channels connecting the components of value chains suggest a broader focus. Two paradoxical insights therefore influence the analysis:
- On the one hand, risk concentration: the more concentrated a network is, the greater the damage caused by an extreme event will be. However, the damage caused in the event of an occurrence would be greater than if the chain were less concentrated.
- On the other hand, risk diversification: in the case of a less concentrated network, even if there is a high probability of an event occurring on one of its components, the damage to the entire circuit can be limited.
To circumvent this paradox, one solution would be to distinguish between production and non-production components. The World Economic Forum’s approach categorizes five components of the value chain (WEF, 2020 to 2024), bearing in mind three key factors that determine the vulnerability of the supply chain: (1) the market, (2) the supply chain, and (3) assets and operations (M. Wagner & Neshat, 2010).
An interesting tool developed by the World Bank offers a four-step approach to assessing a project’s exposure to risk: exposure, impact, adaptation, and final score.
- Sectoral approaches and challenges for assessing the vulnerability of a value chain
Vulnerability to physical risks could be described as: i) a set of characteristics of the system that could be used to assess the level of exposure to risks and ii) the severity of its impacts by measuring the sensitivity of the system and its ability to cope with disruptive events. Four dimensions must therefore be taken into account (Lahmar, Chabchoub, Galasso, & Lamothe., 2018):
- Exposure: The nature of the physical event and the degree to which a system is exposed to significant risk. This could be translated into a map of potential physical variables, events, or indicators defined throughout the supply chain.
- Sensitivity: The extent to which a supply chain or its components are susceptible to risks and corresponds to the degree to which a supply chain is affected by risks. This depends on the criticality of the components of the supply chain, which could be measured by its positioning, mission, or purpose within the network. This sensitivity could be mapped by mapping the components of the supply chain and their role within the network (see section on « Location of Counterparties’ Value Chains »).
- Susceptibility: The extent to which a supply chain or its components are likely to suffer losses due to exposure to disruptions or risks. It could be assessed based on exposure and sensitivity.
- Readiness: The set of attributes that enable the supply chain to adapt to or overcome potential disruptions. It may be related to supply chain trends or maturity level (the degree of awareness of supply chain risk management within supply chain networks).
2) From companies to sectors to countries
2.1 Some examples
The best way to understand how climate risk is transmitted along value chains is to study it through concrete examples. To this end, we have selected a series of examples covering several sectors of the economy:
| Sectors | Type of events | Description of example |
| Agriculture, Food. | Drought in Canada (1999-2005). | A severe drought swept across Canada between 1999 and 2005, causing considerable damage to agriculture, the environment, the economy, and society. The drought was widespread, extending from British Columbia to the Atlantic provinces and further north than other major droughts. Agricultural production losses during this drought amounted to nearly $3 billion in the Prairie provinces and an additional $3 billion nationwide. |
| Oil and gas production. | Hurricane (2005). | The paths of five major hurricanes crossed the Gulf of Mexico, significantly disrupting oil and natural gas production. Hurricanes Katrina and Rita crossed the heart of the Gulf production region, leading to widespread shutdowns of production sites. |
| Raw materials manufacturing, car assembly, food production. | Floods in China (2021). | Massive flooding in China (particularly in the Henan region, a major producer of grain and electronic components for mobile phones) is disrupting the country’s supply chain, including the production of food, cars, and coal. Although electricity and transport infrastructure have been restored in the country, the damage caused by several days of heavy rain has affected the production and distribution of goods in several regions. |
| Insurance, automotive, electronics manufacturing. | Rainfall in Thailand (2011). | In 2011, months of torrential rains saturated the Thai countryside, flooding more than two-thirds of the country, killing hundreds of people, and devastating the economy. The impact of the disaster was not limited to Thailand, and according to the United Nations Office for Disaster Risk Reduction, these floods reduced global industrial production by 2.5%; and the damage cost the world’s three largest non-life insurance companies $5.3 billion in claims, more than the cost of the earthquake and tsunami in Japan earlier that year.
Electronics manufacturers and carmakers were particularly hard hit: Western Digital—which produces one-third of the world’s hard drives—lost 45% of its shipments, while Toyota, Honda, and Nissan lost 240,000, 150,000, and 33,000 vehicles, respectively. |
| Transport | Floods in Germany (2021). | Heavy rains and flooding severely affected parts of Western Europe, with the most severe flooding occurring in Germany and Belgium.
According to Huxley, railways from the Czech Republic and Slovakia to the German ports of Rotterdam and Hamburg were severely disrupted. |
2.2 Financing adaptation and the cost of damage
Among the decisions taken at COP28, a « loss and damage » fund with a minimum financing level of USD 200 million was created and will be managed by the World Bank during a four-year transitional period. The aim of this fund is to finance the adaptation of countries vulnerable to climate risks and to strengthen international cooperation on this issue.
Ultimately, the funding pledges made by countries amounted to $700 million (mostly from Europe), compared to the initial 2009 commitments to provide $100 billion per year to cover an estimated $500 billion in losses suffered by the 55 most vulnerable countries over the last two decades, according to the UN. A board of directors will be set up to define the operating rules.
Among the databases made available by the European Commission is the Inform Risk Index, which contains indicators developed in accordance with the IPCC approach. The reference approach is based on three components: exposure, vulnerability, and risk. Country vulnerability scores can be mapped to understand the concentration of risks in the most exposed and least adapted areas (see Figure 1).
Figure 1 Country vulnerability to physical risk according to IPCC data
Conclusion
The current structure of globalized production chains makes it difficult to estimate the indirect damage caused by climate events on production chains. Indeed, the complexity of globalized value chains and the diverse location of risk requires the selection of various databases to accurately measure exposure to random events.
The amount allocated by the damage fund following COP28 has been strongly criticized by the scientific community as insufficient to cover the extent of the risk. The main conclusion of these analyses is that exposure to climate damage depends not only on the location of the country or company concerned, but also on the exposure of the sectors and countries connected to the same structure.
