And don’t forget the climate . . . The changing climate is poised to create a wide array of economic, business, and social risks over the next three decades. Leaders should start integrating climate risk into their decision making now.

McKinsey Global Institute (MGI)

After more than 10,000 years of relative stability—the full span of human civilization— the Earth’s climate is changing. Since the 1880s, the average global temperature
has risen by about 1.1 degrees Celsius, driving substantial physical impact in regions around the world. As average temperatures rise, acute hazards such as heat waves and floods grow in frequency and severity, and chronic hazards such as drought and rising sea levels intensify. These physical risks from climate change will translate into increased socioeconomic risk, presenting policy makers and business leaders with a range of questions that may challenge existing assumptions about supply-chain resilience, risk models, and more.

To help inform decision makers around the world so that they can better assess, adapt to, and mitigate the physical risks of climate change, the McKinsey Global Institute (MGI) recently released a report, Climate risk and response: Physical hazards and socioeconomic impact. (For more on the methodology behind the report, see sidebar

“About the research.”) Its focus is on understanding the nature and extent of physical risk from a changing climate over the next three decades, absent possible adaptation measures.

This article provides an overview of the report. We explain why a certain level of global warming is locked in and illustrate the kinds of physical changes that we can expect as a result. We examine closely four of the report’s nine case studies, showing how physical change might create significant socioeconomic risk at a local level. Finally, we look at some of the choices most business leaders will have to confront sooner than later.

Our hope is that this work helps leaders assess the risk and manage it appropriately for their company. The socioeconomic effects of a changing climate will be large and often unpredictable. Governments, businesses, and other organizations will have to address the crisis in different and often collaborative ways. This shared crisis demands a shared response. Leaders and their organizations will have to try to mitigate the effects of climate change even as they adapt to the new reality it imposes on our physical world. To do so, leaders must understand the new climate reality and its potential impact on their organizations in different locales around the world.

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About the research

This article was adapted from the McKinsey Global Institute (MGI) report Climate risk and response: Physical hazards and socioeconomic impacts.1 Its authors are Jonathan Woetzel (a director of MGI and a
senior partner in McKinsey’s Shanghai office), Dickon Pinner (senior partner in the San Francisco office and global leader of McKinsey’s Sustainability Practice), Hamid Samandari (senior partner in the New York office and chair of McKinsey’s knowledge council), Hauke Engel (partner in the Frankfurt office), Mekala Krishnan (senior fellow at MGI), Brodie Boland (associate partner in the Washington, DC, office), and Carter Powis (consultant in the Toronto office).

The 131-page MGI report, released
in January 2020, measures the impact of climate change based on the extent to which it could affect human beings, human-made physical assets, and the natural world. Most of the climatological analysis performed for the report was completed by the Woods Hole Research Center. There are a range of estimates for the
pace of global warming; we have chosen the Representative Concentration Pathway (RCP) 8.5 scenario because it enables us to assess physical risk in the absence of further decarbonization. Action to reduce emissions could delay projected outcomes. Download the full report on McKinsey.com.

1 See “Climate risk and response: Physical hazards and socioeconomic impacts,” McKinsey Global Institute, January 2020, McKinsey.com.

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The new climate reality

Some climate change is locked in.

The primary driver of temperature increase
over the past two centuries is the human-caused rise in atmospheric levels of carbon dioxide
(CO2) and other greenhouse gases, including methane and nitrous oxide. Since the begin-
ning of the Industrial Revolution in the mid-18th century, humans have released nearly 2.5 trillion metric tons of CO2 into the atmosphere, raising atmospheric CO2 concentrations by 67 percent. Carbon dioxide lingers in the atmosphere for hundreds of years. As a result, nearly all of the warming that occurs is permanent, barring large-scale human action to remove CO2 from the atmosphere. Furthermore, the planet will continue to warm until we reach net-zero emissions.

If we don’t make significant changes, scientists predict that the global average temperature
may increase by 2.3 degrees Celsius by 2050, relative to the preindustrial average. Multiple lines of evidence suggest that this could trigger physical feedback loops (such as the thawing of permafrost leading to the release of significant amounts of methane) that might cause the planet to warm for hundreds or thousands of years. Restricting warming to below 1.5 or 2.0 degrees would reduce the risk of the earth entering such a “hothouse” state.

The nature of climate-change risk

Stakeholders can address the risk posed by climate change only if they understand it clearly and see the nuances that make it so complicated to confront. We find that physical climate risk has seven characteristics:

• Increasing. Physical climate risks are generally increasing across the globe, even though some countries may find some benefits (such as increased agricultural yields in Canada, Russia, and parts of northern Europe). The increased physical risk would also increase socioeco- nomic risk.

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• Spatial. Climate hazards manifest locally. There are significant variations between countries and even within countries. The direct effects of physical climate risk must be understood in the context of a geographically defined area.

• Nonstationary. For centuries, financial markets, companies, governments, and individuals have made decisions against the backdrop of a stable climate. But the coming physical climate risk is ever-changing and nonstationary. Replacing a stable environment with one of constant change means that decision making based on experience may prove unreliable. For example, long-accepted engineering parameters for infrastructure design may need to be rethought; homeowners and banks may need to adjust assumptions about long-term mortgages.

• Nonlinear. Physiological, human-made, and ecological systems have evolved or been optimized over time to withstand certain thresholds. Those thresholds are now being threatened. If or when they are breached, the impact won’t be incremental—the systems may falter, break down, or stop working altogether. Buildings designed to withstand floods of a certain depth won’t withstand floods of greater depths; crops grown for a mild climate will wither at higher temperatures. Some adaptation can

be carried out fairly quickly (for example, better preparing a factory for a flood). But natural systems such as crops may not be able to keep pace with the current rate
of temperature increase. The challenge becomes even greater when multiple risk factors are present in a single region.

• Systemic. Climate change can have knock-on effects across regions and sectors, through interconnected socioeconomic and financial systems. For example, flooding in Florida might not only damage housing but also raise insurance costs, lower property values, and reduce property-tax revenues. Supply chains are particularly vulnerable systems, since they prize efficiency over resilience. They might quickly grind to a halt if critical production hubs are affected by intensifying hazards.

• Regressive. The poorest communities and populations of the world are the most vulnerable. Emerging economies face the biggest increase in potential impact on workability and livability. The poorest countries often rely on outdoor work and natural capital, and they lack the financial means to adapt quickly.

• Unprepared. Our society hasn’t confronted a threat like climate change, and we are unprepared. While companies and communities are already adapting, the pace and scale of adaptation must accelerate. This acceleration may well entail rising costs and tough choices, as well as coordinated action across multiple stakeholders.

How climate risk plays out on a local level

There is already plenty of evidence of the extensive damage that climate risk can inflict. Since 2000, there have been at least 13 climate events that have resulted in significant negative socioeconomic impact, as measured by the extent to which it disrupted or destroyed “stocks” of capital—people, physical, and natural. The events include lethal heat waves, drought, hurricanes, fires, flooding, and depletion of water supply.

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More frequent and more intense climate hazards will have large consequences. They are likely to threaten systems that form the backbone of human productivity by breaching historical thresholds for resilience. Climate hazards can undermine livability and workability, food systems, physical assets, infrastructure services, and natural capital. Some events strike at multiple systems at once. For example, extreme heat can curtail outdoor work, shift food systems, disrupt infrastructure services, and endanger natural capital such as glaciers. Extreme precipitation and flooding can destroy physical assets and infrastructure while endangering coastal and river communities. Hurricanes can damage global supply chains, and biome shifts can affect ecosystem services.

The best way to see how this will play out is to look at specific cases. MGI looked at nine distinct cases of physical climate risk in a range of geographies and sectors. Each considers the direct impact and knock-on effects of a specific climate hazard in a specific location, as well as adaptation costs and strategies that might avert the worst outcomes. Let’s look at four of those cases (see also sidebar “Global problem, local impact”).

Will it get too hot to work in India?

The human body provides one example of the nonlinear effect of breaching physical thresholds. The body must maintain a relatively stable core temperature of approximately 37 degrees Celsius to function properly. An increase of just 0.9 of a degree compro- mises neuromuscular coordination; 3 degrees can induce heatstroke; and 5 degrees can cause death. In India, rising heat and humidity could lead to more frequent breaches

of these thresholds, making outdoor work far more challenging and threatening the lives of millions of people.

As of 2017, some 380 million of India’s heat-exposed outdoor workers (75 percent of the labor force) produced about 50 percent of the country’s GDP. By 2030, 160 million to 200 million people could live in urban areas with a nonzero probability of such heat waves occurring. By 2050, the number could rise to between 310 million and 480 million. The average person living in these regions has a roughly 40 percent chance of experi- encing a lethal heat wave in the decade centered on 2030. In the decade centered on 2050, that probability could rise to roughly 80 percent.

India’s productivity could suffer. Outdoor workers will need to take breaks to avoid heat- stroke. Their bodies will protectively fatigue, in a so-called self-limiting process, to avoid overheating. By 2030, diminished labor productivity could reduce GDP by between 2.5 and 4.5 percent.

India does have ways to adapt. Increased access to air-conditioning, early-warning systems, and cooling shelters can help combat deadly heat. Working hours for outdoor personnel could be shifted, and cities could implement heat-management efforts. At
the extreme, coordinated movement of people and capital from high-risk areas could be organized. These would be costly shifts, of course. Adaptation to climate change will

be truly challenging if it changes how people conduct their daily lives or requires them to move to areas that are less at risk.

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Will mortgages and markets stay afloat in Florida?

Florida’s expansive coastline, low elevation, and porous limestone foundation make it vulnerable to flooding. The changing climate is likely to bring more severe storm surge from hurricanes and more tidal flooding. Rising sea levels could push salt water into the freshwater supply, damaging water-management systems. A once-in-100-years hurricane (that is, a hurricane of 1 percent likelihood per year) would damage about

$35 billion in real estate today. By 2050, the damage from such an event could be $50 billion—but that’s just the beginning. The accompanying financial effects may be even greater.

Real estate is both a physical and a financial store of value for most economies. Damage, and the expectation of future damage, to homes and infrastructure could drive down
the prices of exposed homes. The devaluation could be even more significant if climate hazards also affect public-infrastructure assets such as water, sewage, and transpor- tation systems, or if homeowners increasingly factor climate risk into buying decisions.

Lower real-estate prices could have significant knock-on effects in a state whose assets, people, and economic activity are largely concentrated in coastal areas. Property-
tax revenue in affected counties could drop 15 to 30 percent, which could lower municipal- bond ratings and the spending power of local governments. Among other things,

that would make it harder for cities and towns to invest in the infrastructure they need to combat climate change.

The impact on insurance and mortgage financing in high-risk areas could also be signif- icant. There’s a duration mismatch between mortgages, which can be 30 years long, and insurance, which is repriced every year. This mismatch means that current risk signals from insurance premiums might not build in the expected risk over an asset’s lifetime, which could lead to insufficiently informed decisions. However, if insurance premiums do rise to account for future climate-change risk, lending activity for new homes could slow, and the wealth of existing homeowners could diminish.

When home values fall steeply with little prospect of recovery, even homeowners who are not financially distressed may choose to strategically default. One comparison point is Texas: during the first months after Hurricane Harvey hit Houston, in 2017,
the mortgage-delinquency rate almost doubled, from about 7 to 14 percent. Now, as mortgage lenders start to recognize these risks, they could raise lending rates for risky properties. In some cases, they might even stop providing 30-year mortgages.

To adapt, Florida will have to make hard choices. For example, the state could increase hurricane and flooding protection, or it could curtail—and perhaps even abandon— development in risk-prone areas. The Center for Climate Integrity estimates that 9,200 miles of seawalls would be necessary to protect Florida by 2040, at a cost of $76 billion. Other strategies, such as improving the resilience of existing infrastructure and installing new green infrastructure, come with their own hefty price tags.

Can supply chains weather climate change?

Supply chains are typically optimized for efficiency over resilience, which may make them vulnerable to extreme climate hazards. Any interruption of global supply chains can . . .

There is so much more to read at https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Sustainability/Our%20Insights/Confronting%20climate%20risk/Confronting-climate-risk.ashx

Photo by Markus Spiske on Unsplash

  • McKinsey Global Institute (MGI)