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HomeUncategorizedAs climate risks increase, so do costs for small businesses

As climate risks increase, so do costs for small businesses

As climate risks rise, businesses of all types will have to spend more of their budgets on preparing for and responding to disasters. Investing in risk management can help offset these costs, but many businesses, especially small ones, may not have the financial flexibility to do so. In August 2018, the authors surveyed 273 businesses impacted by Hurricane Harvey (and assessed 5,000 credit reports) to see how they responded after it struck southeastern Texas in 2017. Using this data, the authors illuminate the long-term impact of disasters on businesses and share lessons for policymakers and business owners on how to best prepare their businesses for future risks.

To deal with growing climate risks, businesses will have to set aside more and more cash flow. Hurricanes, wildfires and rising sea levels impose costs on businesses, both in preparing for and responding to these disasters. These costs will only increase over time as the risk increases. Risk management helps minimize the costs of climate change. A robust risk management strategy stratifies financing instruments (insurance, reserves and borrowing) to address different aspects of risk. Doing so can facilitate recovery by giving businesses the funding they need in the event of a disaster. But investing in risk management also has direct costs. Insurance requires prepayment of premiums. A cash reserve needs to hold funds for emergencies. Planning to finance repairs with credit requires the business to remain financially flexible—maintaining sufficient financial position to obtain a loan in the future. So cash-strapped businesses are struggling to adjust. Small businesses, in particular, often operate on razor-thin margins and are busy funding everyday expenses like buying inventory or paying wages. Many feel that they do not have the luxury of devoting resources to risk management. But without it, businesses may face additional challenges that will make it more expensive to recover after a shock. To explore these dynamics, we examined the impact on businesses after Hurricane Harvey hit southeastern Texas in 2017. Hurricane Harvey was the costliest disaster year for the United States in 40 years, causing $125 billion in economic damage. Climate scientists estimate that the storm’s severity has increased by roughly 30 percent due to climate change, making it an example of how the risk of severe storms has grown.

Data We use two methods to study Harvey’s Impact on Local Businesses: Conducting Surveys and Analyzing Business Credit Reports. In August 2018, about a year after the Harvey incident, we surveyed 273 businesses in the affected areas—actually from Greater Houston to Corpus Christi on the Gulf Coast. The companies surveyed were similar in age and size to other companies in the region. Our survey asked detailed questions about any damages they suffered, how they paid for them and how their recovery was going. To complement the survey, we analyzed the credit reports of approximately 5,000 companies in the disaster area and compared their information to 3,000 companies from across the United States that were not on Harvey’s path. While the survey provides a broad range of business experiences and recovery strategies, the credit report provides metrics commonly used by lenders, landlords, supply chain partners and others to assess a company’s financial health, such as whether debt is being paid on time.

What did the business lose? Our survey asked participants questions about their losses from Harvey. Businesses report a variety of complications, but the most dramatic is lost revenue. Almost 90% of businesses surveyed reported a loss of revenue due to Harvey, most commonly in the five-digit range. These revenue losses are caused by employee disruptions, declining customer demand, utility disruptions, and/or supply chain issues. Fewer companies (about 40%) suffered property damage to construction, machinery and/or inventory. Although less common, the average cost of property damage is higher than loss of income. However, property damage compounded the problem of lost revenue by closing businesses: 27% were closed for more than a month, and 17% were closed for more than three months. As a result, companies that suffer property damage lose roughly twice as much revenue. Corporate credit reports after Harvey also show signs of distress. Harvey caused many businesses to default on their debts. In the hardest-flooded areas, the storm increased delinquency balances by 86 percent compared with pre-Harvey levels. This effect was largely limited to short-term delinquencies (less than 90 days in delay); we did not see a significant increase in loan defaults or bankruptcies. This pattern may reflect a huge effort by companies to avoid default on their debts.

How does a business manage revenue and property losses?

Traditionally, comprehensive risk management strategies use insurance to transfer serious risks, such as hurricane-related property damage. But insurance doesn’t cover some losses — including lost revenue due to falling demand, employee disruptions and supply chain issues. Borrowing addresses medium-severity losses; cash reserves address small-scale losses. This tiering is primarily driven by cost. For example, holding large cash reserves has a large opportunity cost. It also requires advance planning and financial due diligence. This layered risk management strategy — insuring large risks, borrowing for medium risks, and using cash for small risks — is not what most businesses do. Only 15% of companies surveyed affected by the record-breaking hurricane received insurance payments. This low insurance coverage stems from businesses not insuring flood and wind hazards (eg, their insurance does not cover these risks) and/or businesses insuring their property but not their income risk. Borrowing also played a small role: 27% of companies surveyed used credit to fund the recovery. Businesses often cannot maintain enough financial flexibility to borrow after a disaster, as half of those applying for new credit are denied. Low-interest disaster loans from the Small Business Administration are the only federal aid provided directly to businesses, but again, businesses have no approved funding. Overall, only one-third of the companies surveyed applied for disaster loans.

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Credit report data also shows the importance of retaining borrowing capacity when disaster strikes. Businesses with no debt balances started borrowing after Harvey. Businesses with existing debt balances, on the other hand, applied for additional credit, but ended up with their balances shrinking, a sign that banks felt they were too financially risky. As a result, businesses often do not use insurance payments and loans, but instead finance their recovery internally. More than half of affected companies rely on ongoing income or cash reserves to pay for repairs. Almost as many turned to “informal” financing: business owners and/or the owners’ family and friends put money into the business after Harvey to stay afloat.

What are the long-term effects?

Our findings show businesses dealing with huge expenses but not having a great way to pay them. These coping strategies add to the cost of the incident. For example, credit delinquency can affect a business’s credit report for years. In addition, relying on friends and family for financial help can have a long-term impact on the success and growth of a business. Informal financing erodes protections that separate the finances of businesses and owners, such as limited liability. Existing research concludes that business owners who use informal financing pursue projects with lower risk (and therefore lower returns). Worrying about losing money from friends or family can stifle an entrepreneur’s investment in the company’s future, leading to slower growth. The challenge of recovery is evident in the responses of the companies surveyed: 48% have not fully recovered after a year. But risk management appears to improve recovery: In our study, firms with at least one form of venture financing were almost twice as likely to recover as those without.

Lessons for policy makers

Many are related to Disaster-related challenges are more acute for companies with ex ante financing constraints, such as limited access to credit. The impact on minority businesses may be especially pronounced. Research shows that under normal circumstances, minority businesses that apply for credit are less likely to receive the line of credit they seek, and they are more likely to close after a major disaster. Financing constraints tend to reduce risk management, as any available funds are used for immediate needs rather than planning for future uncertain events. Reducing financing constraints has been shown to stimulate firm establishment and growth, and our findings suggest that credit expansion policies may also make firms more climate resilient. Our research also provides new insights into why current disaster relief policies, which focus on lending to businesses after suffering losses, have limited impact. Many businesses did not maintain the financial flexibility to fund recovery with five- or six-figure loans after a disaster. To help more businesses and their communities recover, we need policies that encourage a wide range of venture financing instruments. Policies that prioritize financial preparation, such as incentivizing emergency savings and insurance, can be especially valuable.

Lessons from business owners

Our results The importance of organizing venture financing in advance is emphasized. Combining insurance with other sources of funding, such as unused credit or “rainy-day” savings, can help ensure quick access to funds should the need arise. It can be difficult to prioritize these buffers given all the other financial needs of the business, but access to cash in the event of a disaster is critical. This buffer is even more important given the challenges posed by the Covid-19 pandemic and ongoing supply chain disruptions. Not all businesses can build financial buffers in the short term, but even cash-strapped companies can make plans. Proactively planning for disruption can reduce uncertainty in the event of a crisis, for example, by assigning staff responsibilities for key functions and scenario planning with key suppliers. Many of the businesses we surveyed had no business continuity plans; even without other risk management measures, those who made a full recovery after Harvey had about a 30% chance. The Small Business Administration provides resources to get started with such programs.

. . .
Climate risk is increasing the cost of doing business for many companies, and investment risk management is more important than ever. The growing climate threat can be especially challenging for small businesses because they face more financial constraints than larger businesses. Proper risk management can greatly reduce the cost of a disaster, but it requires financial discipline and careful planning. Insurance is available for certain types of damage (such as serious property damage), but in most cases does not cover lost income. Maintaining available debt capacity and building cash reserves are necessary to fill the insurance gap. A sustainable recovery during a crisis depends on a diversification that precedes

disaster struck.



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