By Nitya Pandalai-Nayar, Juanma Castro-Vincenzi, Gaurav Khanna, and Nicolas Morales
The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond and the Board of Governors.
As climate change intensifies, extreme weather events and unpredictable climate patterns pose growing threats to economies worldwide. The ongoing unseasonal fires in densely populated, economically important areas of Los Angeles highlight the risks faced to firms and workers from their location choices, given the growing prevalence of such climate shocks.[1] These risks are particularly acute for supply chains, where disruptions can ripple through entire industries, stalling production and raising costs. From floods to droughts and fires, localized climate shocks threaten to destabilize 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 Castro-Vincenzi, Khanna, Morales and Pandalai-Nayar (2024).
Our paper 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 behavior. By analyzing 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: Localized Risks in a Globalized World
Modern supply chains are highly interconnected and efficient, but they are also vulnerable to disruptions. A localized 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, the stakes are high: 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 destabilize 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 Behavior: Suppliers in high-risk areas may lower their prices to compensate for the perceived risks, introducing further complexity to firms’ decision-making.
Our model is calibrated using data from 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. 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. This strategy 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. These discounts act as a compensatory mechanism, encouraging firms to continue sourcing from high-risk regions despite the associated vulnerabilities.
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. Higher input costs, in turn, can suppress wage growth in supplier regions. Suppliers in high-risk areas often face lower wages, 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, and downstream buyers see a reduction in purchases. Yet, firms quickly adjust and recover, demonstrating the importance of preemptive resilience strategies.
Figure 1 illustrates the short-term sourcing shifts observed after a flood event, showing changes in supplier relationships over time.
Figure 1: Effects of floods on sales and downstream purchases.
Implications: Resilience and Inequality
Our findings have significant implications for firms, workers, and policymakers. First, when thinking about economic resilience, our results argue 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 localized shocks. On the other hand, this leads to regional disparities. That is, 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 project, 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. In panel a of Figure 2, we see that that the Gangetic Plain, the North East, 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 risk. The increase in climate risk will have consequences on welfare (measured by real wages) across regions. Welfare on average decreases by 2.01%. There is wide spatial variation, with a range of 3.11pp, 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 get the direct effect of climate change and are expected to face lower demand for their inputs, as demand moves to safer regions.
Figure 2: Expected changes in climate risk and their welfare consequences.
Together, these raise policy challenges. Policymakers must address the trade-offs inherent in these dynamics. For example, incentives to bolster infrastructure in high-risk areas could help reduce supplier vulnerabilities, while targeted wage subsidies might alleviate the economic burden on workers in these regions. Our findings underscore the need for proactive interventions to enhance supply chain resilience while minimizing negative economic consequences. Governments and firms 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. Furthermore, policy measures, such as tax incentives or subsidies for supply chain diversification, could help firms manage the higher costs associated with resilience strategies. Finally, policy makers must address wage inequalities, by targeting policies to support workers in climate-vulnerable regions. Such skill development programs, or income support could mitigate the adverse wage effects identified in our study.
Conclusion
As climate risks such as the Los Angeles wildfires grow, firms are increasingly compelled to rethink their supply chain strategies. Our paper 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.
Bibliography
Castro-Vincenzi, Juanma, Khanna, Gaurav, Morales, Nicolas and Nitya Pandalai-Nayar, 2024. “Weathering the Storm: Supply Chains and Climate Risk,” NBER working paper No. 32218, March.
[1] Estimates of the losses from property damage due to these fires is upwards of $200 billion.
