How firms adapt supply chains to climate risk

Amidst growing climate risks, localised weather events such as floods or droughts pose a threat to the links between firms and their suppliers. Using data from India, this article analyses how businesses adapt their sourcing strategies to mitigate climate risks, and the broader economic implications of their responses. It finds that while supply chain diversification by firms enhances economic stability, it may deepen regional disparities.

As climate change intensifies, extreme weather events and unpredictable climate patterns pose growing threats to economies worldwide. These risks are particularly acute for supply chains, where disruptions can ripple through entire industries, stalling production, and raising costs. From floods to droughts, localised climate shocks threaten to destabilise the links between firms and their suppliers. How do firms adapt to these challenges? And what are the broader economic implications of their responses? These questions lie at the heart of our recent research (Castro-Vincenzi et al. 2024).

Our study focuses on India, a country that is highly exposed to climate risks and where regional disparities in climate vulnerability create a natural laboratory for studying firm behaviour. By analysing rich firm-to-firm transaction data alongside regional climate risk indicators, we uncover how businesses adapt their sourcing strategies to mitigate climate risks – and the trade-offs these adaptations entail.

The challenge: Localised risks in a globalised world

Modern supply chains are highly interconnected and efficient, but they are also vulnerable to disruptions. A localised climate shock in one region – such as flooding or a severe drought – can have far-reaching consequences, especially if firms rely heavily on suppliers in the affected area. For firms, a disrupted supply chain can lead to production delays, missed deadlines, and significant financial losses.

For policymakers, the problem is equally pressing. Climate-induced supply chain disruptions can destabilise local economies, depress wages, and widen regional inequalities. Understanding how firms adapt to these risks is essential for designing policies that foster resilience without exacerbating existing disparities.

Tackling the problem: Data and methods

To explore how firms respond to climate risk, we leverage a detailed dataset of firm-to-firm transactions from an Indian state. This dataset provides granular information on sourcing relationships – which suppliers each firm works with and where those suppliers are located. These data are paired with regional climate risk measures, such as the frequency and severity of extreme weather events.

Importantly, we develop a ‘general equilibrium spatial model’ to simulate how firms make decisions about their supplier networks. The model accounts for key trade-offs:

Risk diversification: Firms can mitigate climate risks by diversifying their supplier base geographically, reducing reliance on any single region.
Cost trade-offs: Diversification often comes with higher costs, as sourcing from additional suppliers or more distant regions can increase logistical and operational expenses.
Supplier behaviour: Suppliers in high-risk areas may lower their prices to compensate for the perceived risks, introducing further complexity to firms' decision-making.

We combine our data on firm-to-firm transactions, with data on firm output from the Annual Survey of Industries (ASI), data on climate from the World Resources Institute’s Aqueduct Floods Hazard Map and the Indian Meteorological Department, and climate projections from the IPCC (Intergovernmental Panel on Climate Change). We use these data to calibrate our model to 271 regions in India, capturing the interplay between climate risks, supply chain dynamics, and regional economic outcomes.

Key empirical findings: How firms adapt

Our analysis reveals clear patterns in how firms respond to climate risks. First, we argue that there is supply chain diversification – 96.5% of total purchases come from firms with more than one supplier-district. Firms in regions exposed to high climate risk are more likely to diversify their supply chains, sourcing identical inputs from multiple suppliers spread across different areas. Firms that source from five different districts have 17% higher rainfall than firms that source from just one district (Figure 1, left panel). This strategy of supplier diversification ensures that a disruption in one region does not halt production entirely.

Second, there are price adjustments by suppliers. Suppliers located in climate-vulnerable areas often reduce their prices to retain buyers. A 10% increase in floods in a supplier’s district, is associated with those suppliers charging about 2.6% lower prices. These discounts act as a compensatory mechanism, encouraging firms to continue sourcing from high-risk regions despite the associated vulnerabilities.

Figure 1. Supplier characteristics by number of districts sourced from

Third, we highlight the trade-offs in wages and costs. While diversification reduces the likelihood of supply chain disruptions, it also raises input costs for firms. Firms that buy from multiple supplier districts, pay higher prices, on average (Figure 1, right panel). Higher input costs, in turn, can suppress wage growth in supplier regions, reflecting the economic consequences of climate vulnerability.

Fourth, we describe the impact of floods on supply chains. ‘Event study’ analyses reveal that when suppliers are hit by floods, suppliers see a temporary fall in sales (of about 0.1 log points), and downstream buyers see a reduction in purchases. Yet, firms quickly adjust and recover, demonstrating the importance of preemptive resilience strategies. Figure 2 illustrates the short-term sourcing shifts observed after a flood event, showing changes in supplier relationships over time.

Figure 2. Effects of floods on sales (left panel) and downstream purchases (right panel)

Implications: Resilience and inequality

Our findings have significant implications for firms, workers, and policymakers. First, when thinking about economic resilience, our results show that supply chain diversification reduces the risk of large-scale disruptions, contributing to overall economic stability. By spreading risk across multiple regions, firms can better withstand localised shocks. On the other hand, this adaptation strategy can deepen regional inequalities. Areas prone to frequent climate shocks face declining wages and reduced investment, while more resilient regions maintain or even improve their economic standing.

In the next 25 years, climate-related disasters are expected to increase for some regions while dampen for others. In our research, we use the predicted change in flooding, rainfall, and heat levels by year 2050 to understand how different Indian regions will be affected as well as quantifying how much supply chains can amplify these effects. For instance, the Gangetic Plain, the Northeast, and parts of Gujarat and Tamil Nadu, are expected to face more disruptions, while parts of Andhra Pradesh are expected to have relatively lower climate risk¹. The increase in climate risk will have consequences on welfare (measured by real wages) across regions. On average, welfare decreases by about 2%. There is wide spatial variation, with a range of 3.11 percentage points, and some of the less risky regions see welfare gains. Supply chains contribute to amplify gains and losses created by climate change. Regions getting riskier will experience the direct effect of climate change and are expected to face lower demand for their inputs, as demand moves to safer regions.

Together, these dynamics raise policy challenges, in terms of the need to address the inherent trade-offs. Our findings underscore the need for proactive interventions to enhance supply chain resilience while minimising negative economic consequences. For example, governments can invest in infrastructure and technologies that reduce the vulnerability of suppliers in high-risk regions, such as flood-resistant facilities or advanced logistics systems. Such investment may be made directly by governments or by incentivising firms to do so.

Furthermore, policymakers must address wage inequalities, by targeting policies such as skill programme, wage subsidies or income support towards workers in climate-vulnerable regions, in order to alleviate their economic burden. Finally, policy measures, such as tax incentives or subsidies for supply chain diversification, could help firms manage the higher costs associated with resilience strategies.

Conclusion

As climate risks grow, firms are increasingly compelled to rethink their supply chain strategies. Our research provides a detailed view of how businesses navigate these challenges, offering valuable insights for policymakers and industry leaders alike. While supply chain diversification enhances resilience, it also underscores the uneven economic consequences of climate adaptation. Policymakers must act to balance these trade-offs, ensuring that the push for resilience does not come at the cost of greater inequality. By addressing these complexities, we can build a more equitable and climate-resilient economy for the future.

Note:

The change in climate risk probabilities depends on rainfall, coastal flooding, riverine flooding, temperature, and a standardised precipitation index.