To address growing climate risks, businesses will have to set aside an increasing share of their cash flows. Hurricanes, wildfires, and the rise in sea levels impose costs on firms, both in preparation and response to these disasters. As the risks grow, those costs are only going to increase over time.
Risk management can help minimize the cost of climate change. Robust risk management strategies layer financing tools — insurance, reserving, and borrowing — to address different aspects of the risk. Doing so facilitates recovery by providing businesses the funds they need when disaster strikes.
But investing in risk management also imposes immediate costs. Insurance requires upfront premium payments. Cash reserves require keeping funds set aside for a rainy day. Planning to fund repairs with credit requires businesses to maintain financial flexibility — keeping enough slack in their finances to access a loan in the future.
As a result, cash-strapped businesses are struggling to adjust. Small business in particular often operate on thin margins, hustling to fund day-to-day expenses like purchasing inventory or meeting payroll. Many don’t feel they have the luxury to dedicate resources to risk management. But without it, businesses may face additional challenges that will make recovery more costly in the wake of a shock.
To explore these dynamics, we studied how Hurricane Harvey affected businesses after it struck Southeast Texas in 2017. Harvey was the costliest event — causing $125 billion in economic damages — in the costliest disaster year for the U.S. in four decades. Climate scientists estimate that the storm was about 30% more severe due to climate change, making it an example of how the risks of severe storms are growing.
The Data
We studied Harvey’s effect on local businesses using two methods: conducting a survey and analyzing business credit reports.
In August 2018, roughly one year after Harvey, we surveyed 273 businesses in the affected area — effectively from greater Houston to Corpus Christi on the Gulf Coast. Surveyed firms were similar in age and size to other firms in the region. Our survey asked detailed questions about any losses they incurred, how they paid for them, and how their recovery was progressing.
To complement the survey, we analyzed the credit reports of about 5,000 firms in the disaster area and compared their information to 3,000 firms from around the U.S. who were not in Harvey’s path. While the survey offers a broad sense of businesses’ experiences and recovery strategies, credit reports provide metrics commonly used by lenders, landlords, supply chain partners, and others to assess the firm’s financial health such as whether it pays its debts on time.
What Did Businesses Lose?
Our survey asked participants questions about their losses from Harvey. Businesses reported a variety of complications, but the most striking were revenue losses. Almost 90% of surveyed businesses reported losing revenue because of Harvey, most commonly in the five-figure range. These revenue losses were caused by employee disruptions, lower customer demand, utility outages, and/or supply chain issues.
Fewer firms (about 40%) experienced property damage to their building, machinery, and/or inventory. While less common, property damage losses were more costly on average than lost revenue. However, property damage compounded the issue of lost revenue by keeping the business closed: 27% with property damage closed for over a month, and 17% closed for over three months. As a result, revenue losses were about twice as large for firms who experienced property damage.
Businesses’ credit reports after Harvey show signs of distress as well. Harvey caused many businesses to fall behind on their debt payments. In the worst-flooded areas, the storm increased delinquent balances by 86% compared to their pre-Harvey levels. This effect is mostly limited to shorter-term delinquencies (fewer than 90 days late); we do not find a significant increase in loan defaults or bankruptcies. This pattern likely reflects businesses’ substantial efforts to avoid defaulting on their debts.
How Did Businesses Manage Revenue and Property Losses?
A comprehensive risk management strategy traditionally uses insurance to transfer severe risks like hurricane-related property damages. But insurance doesn’t cover some losses — including revenue losses due to lower demand, employee disruptions, and supply chain issues. Borrowing addresses moderate-severity losses; cash reserves address small-scale losses. This layering is primarily driven by cost; for example, holding large cash reserves has a big opportunity cost. It also requires up-front planning and financial diligence.
This layered risk management strategy — insuring the big risks, borrowing for the moderate, and using cash for the small — isn’t what most businesses did. Only 15% of surveyed firms affected by this record-breaking hurricane received a payment from insurance. This low insurance coverage stems from businesses being uninsured for flood and wind damages (e.g., they had insurance that excluded coverage for these perils) and/or businesses insuring their property but not their revenue exposures.
Borrowing also played a small role: 27% of surveyed firms used credit to finance recovery. Businesses often had not maintained enough financial flexibility to borrow after the disaster, as half of those who applied for new credit were denied. Low-interest disaster loans from the Small Business Administration are the only federal government assistance offered directly to businesses, but again, businesses did not have the finances to be approved. In total, only one-third of surveyed firms who applied for a disaster loan were approved.
The credit report data similarly show how important preserved borrowing capacity is when disaster strikes. Businesses who didn’t carry debt balances started borrowing after Harvey. Businesses who had existing debt balances, on the other hand, applied for additional credit, but ultimately their balances decreased, a sign that banks viewed their finances as too risky.
As a result, instead of using insurance payments and loans, businesses typically financed their recovery internally. More than half of affected firms relied on continued revenue or cash reserves to pay for repairs. Nearly as many turned to “informal” financing: the business owner and/or the owner’s family and friends put money into the business after Harvey to keep it afloat.
What Are the Long-Term Implications?
Our findings offer a picture of businesses coping with large expenses, but without a good way to pay for them. These coping strategies can add to the cost of the event. For example, credit delinquencies blight a business’ credit reports for years.
Additionally, relying on financial help from friends and family may have long-term effects on the success and growth of the business. Informal financing erodes protections that separate the finances of the business and the owner, such as limited liability. Existing research concludes that business owners who use informal financing pursue lower risk (and thus lower return) projects than they otherwise would. Concerns about losing a friend’s or family member’s money stifles the entrepreneur’s investment in the future of the firm, leading to slower growth.
The challenges of recovery are apparent in the responses of surveyed firms: Forty-eight percent had not fully recovered one year later. But risk management appears to improve recovery: firms in our study who had at least one form of risk financing were almost twice as likely to have recovered as those with none.
Lessons for Policymakers
Many of the disaster-related challenges are worse for firms with pre-event financing constraints such as limited access to credit. The effects may be especially pronounced for minority-owned businesses. Research shows that, during normal times, minority-owned businesses who apply for credit are less likely to receive the amount of credit they seek and that they are more likely to close after a major disaster. Financing constraints tend to reduce risk management because any available funds are used for immediate needs rather than planning for uncertain events in the future. Reducing financing constraints has been shown to spur business establishment and growth, and our findings suggest that credit expansion policies may also make firms more climate resilient.
Our research also offers new insights on why current disaster relief policies, which focus on lending to businesses after a loss, have limited reach. Many businesses have not maintained the financial flexibility to fund recovery with a five- or six-figure loan after disaster strikes. To help more businesses and their communities recover, we need policies that encourage a wide range of risk financing tools. Policies prioritizing financial preparedness, such as incentivizing emergency savings and insuring, may be especially valuable.
Lessons for Business Owners
Our results highlight the importance of organizing risk financing upfront. Combining insurance with other sources of funds, such as unused credit or “rainy day” savings, helps to ensure money is quickly accessible in situations of need. It can be difficult to prioritize these buffers given all the other financial demands on a business, but having access to cash is essential when disaster strikes. Such buffers are even more important given the challenges created by the Covid-19 pandemic and ongoing supply chain disruptions.
Establishing financial buffers in the short term is not possible for all businesses, but even cash-strapped firms can have a plan. Proactively planning for interruptions reduces uncertainty when a crisis occurs by, for example, laying out employee responsibility for critical functions and scenario planning with key vendors. Many businesses that we surveyed did not have a business continuity plan; those that did were about 30% more likely to have fully recovered following Harvey even if they had no other risk management in place. The Small Business Administration offers resources for getting started with this type of plan.
Climate risks are increasing the cost of doing business for many companies, and investing in risk management is more important than ever. Growing climate threats may be especially challenging for small businesses as they face more financial constraints than larger firms. Proper risk management can substantially reduce the cost of a disaster, but requires financial discipline and careful planning. Insurance works well for some types of losses (such as severe property damage), but will not cover lost revenue in most cases. Maintaining available debt capacity and building cash reserves are necessary to fill the gaps in insurance. Sustainable recovery during a crisis hinges on having a diverse set of financing tools in place before disaster strikes.
Courtesy- https://hbr.org/2022/08/as-climate-risk-grows-so-will-costs-for-small-businesses