As climate risk increases, so will the costs to small businesses

To deal with growing climate risks, businesses will need to allocate an ever-increasing share of their cash flows. Hurricanes, wildfires, and sea-level rise impose costs on businesses, both in preparing for and responding to these disasters. As the risks increase, these costs will only increase over time.

Risk management can help minimize the costs of climate change. Robust risk management strategies include financing tools – insurance, reserving and borrowing – to address various aspects of risk. This facilitates recovery by providing businesses with 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 rainy days. Planning to finance renovations with credit requires businesses to maintain financial flexibility—keeping enough slack in their finances to access a loan in the future.

As a result, businesses with financial difficulties are struggling to adjust. Small businesses, in particular, often operate on thin margins, rushing to fund day-to-day expenses such as purchasing inventory or covering payroll. Many do not feel they have the luxury to devote resources to risk management. But without it, businesses may face additional challenges that will make recovery from the shock more expensive.

To explore this dynamic, we examined how Hurricane Harvey affected businesses after it hit Southeast Texas in 2017. Harvey was the costliest event—causing $125 billion in economic damage—in the costliest U.S. disaster year in four decades. Climate scientists estimate that the storm was about 30 percent more severe because of climate change, making it an example of how the risks of severe storms are increasing.

The data

We investigated 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. The surveyed firms are similar in age and size to other firms in the region. The survey asked us detailed questions about any losses they incurred, how they paid for them, and how their recovery was progressing.

To supplement the study, we analyzed the credit reports of approximately 5,000 businesses in the disaster area and compared their information to 3,000 businesses across the U.S. that were not in Harvey’s path. While the survey offers broad insight into a business’s track record and recovery strategies, credit reports provide metrics commonly used by lenders, lessors, supply chain partners and others to assess a business’s financial health, such as whether it is repaying debts you are on time

What did the companies lose?

Our survey asked participants questions about their Harvey losses. Businesses report a variety of complications, but the most striking are lost revenues. Almost 90% of businesses surveyed reported a loss of revenue due to Harvey, most often in the five-figure range. These revenue losses are caused by employee disruptions, lower customer demand, utility outages and/or supply chain issues.

Fewer firms (about 40%) had property damage to their buildings, machinery and/or inventory. Although less common, property damage losses are, on average, more expensive than lost income. However, property damage compounded the problem of lost revenue by keeping businesses closed: 27% with property damage closed for more than a month and 17% closed for more than three months. As a result, revenue losses are about twice as great for businesses that have suffered property damage.

Post-Harvey business credit reports are also showing signs of distress. Harvey caused many businesses to default on their debt payments. In the worst-hit areas, the storm increased delinquent balances by 86 percent from pre-Harvey levels. This effect is mostly limited to shorter-term arrears (less than 90 days late); we find no significant increase in delinquent loans or bankruptcies. This pattern likely reflects significant efforts by businesses to avoid defaulting on their debts.

How did firms manage property income and losses?

A comprehensive risk management strategy has traditionally used insurance to transfer serious risks, such as property damage related to hurricanes. But insurance doesn’t cover some losses — including lost revenue due to lower demand, employee disruptions and supply chain issues. Borrowing is aimed at losses of moderate severity; cash reserves cope with small losses. This layering is primarily determined by cost; for example, holding large cash reserves has a large opportunity cost. It also requires advance planning and financial diligence.

This multi-layered risk management strategy – insuring the big risks, borrowing the moderate ones and using cash for the small ones – is not what most firms do. Only 15% of surveyed businesses affected by this record-breaking hurricane received payment from insurance. This low insurance coverage stems from businesses not being insured for flood and wind damage (eg they had insurance that excluded coverage for these perils) and/or businesses insuring their property but not their income.

Loans also play a small role: 27% of the companies surveyed used credit to finance a rebuild. Businesses often did not maintain 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 the businesses surveyed that applied for a disaster loan were approved.

Credit report data similarly shows how important retained borrowing capacity is when disaster strikes. Businesses that didn’t have debt balance sheets began borrowing after Harvey. Businesses that had existing debt balances, on the other hand, applied for additional credit but eventually saw their balances decline, a sign that banks viewed their finances as too risky.

As a result, rather than using insurance payments and loans, businesses typically finance their recovery internally. More than half of the affected businesses rely on recurring revenue or cash reserves to pay for repairs. Almost 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 consequences?

Our findings offer a picture of businesses dealing with large costs but without a good way to pay for them. These coping strategies can increase the cost of the event. For example, delinquent loans tarnish business credit reports for years.

Additionally, relying on financial help from friends and family can have a long-term impact on the success and growth of a business. Informal financing undermines protections that separate business and owner finances, such as limited liability. Existing research concludes that business owners who use informal finance pursue projects with lower risk (and therefore lower returns) than they would otherwise. Worries about losing a friend or family member’s money stifle the entrepreneur’s investment in the firm’s future, leading to slower growth.

The challenges of recovery are evident in the responses of the companies surveyed: forty-eight percent have not fully recovered one year later. But risk management does seem to improve recovery: firms in our study that had at least one form of venture financing were almost twice as likely to recover as those with none.

Lessons for politicians

Many of the challenges associated with disasters are worse for businesses with financial constraints prior to the event, such as limited access to credit. The effects can be particularly pronounced for minority-owned businesses. Research shows that in normal times, minority-owned businesses that apply for credit are less likely to get the amount of credit they seek and that they are more likely to close after a major disaster. Financial constraints lead to a reduction in risk management, as all available funds are used for immediate needs rather than planning for uncertain events in the future. Reducing financial constraints has been shown to stimulate business establishment and growth, and our findings suggest that credit expansion policies can also make firms more climate resilient.

Our research also offers new insights into why current disaster relief policies that focus on lending to businesses after a loss have limited reach. Many businesses have not retained the financial flexibility to finance recovery with a five- or six-figure loan after a disaster. To help more businesses and their communities recover, we need policies that encourage a broad range of venture finance tools. Policies prioritizing financial preparedness, such as encouraging emergency savings and insurance, can be particularly valuable.

Lessons for business owners

Our results highlight the importance of pre-arranging venture financing. Combining insurance with other sources of funds, such as unused credit or savings for a “black day”, helps ensure that money is quickly available in situations of need. It can be difficult to prioritize these buffers given all the other financial demands on the business, but access to cash is essential when disaster strikes. Such buffers are all the more important given the challenges created by the Covid-19 pandemic and ongoing supply chain disruptions.

Creating financial buffers in the short term is not possible for all businesses, but even businesses with financial difficulties can have a plan. Proactive disruption planning reduces uncertainty in the event of a crisis by, for example, assigning employee responsibility for critical functions and scenario planning with key suppliers. Many businesses we surveyed did not have a business continuity plan; those who did were about 30 percent more likely to fully recover from Harvey, even if they had no other risk management. The Small Business Administration offers resources for getting started with this type of plan.

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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 can be particularly challenging for small businesses, as they face more financial constraints than larger firms. Proper risk management can significantly reduce the cost of a disaster, but it requires financial discipline and careful planning. Insurance works well for some types of losses (such as severe property damage), but in most cases it will not cover lost income. Maintaining available debt capacity and building cash reserves are necessary to fill insurance gaps. A sustainable recovery during a crisis depends on the availability of a diverse set of financing instruments before disasters strike.

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