Flying blind on physical risks: The missing money on the balance sheet

The Earth’s climate has already warmed by approximately 1.0^°C above pre-industrial levels. Profound changes are locked into the climate system even if man-made greenhouse gas emissions stopped tomorrow. More frequent and more extreme weather and climate events, as well as gradual shifts in rainfall patterns, temperature, sea levels, sea ice and glacial retreat, are some of the changes already underway.

The warming of the Earth’s climate has brought the issues of adaptation and resilience to the forefront of investor attention and the world at COP26. In addition, a changing climate is increasingly understood as posing significant financial risks. Despite this growing awareness of the issue and the pressure for investors to report on how climate change impacts them, driven by the Task Force on Climate-Related Financial Disclosures, the reality is that physical climate risk analysis still constitutes a major challenge for financial institutions and investors.

Most climate analysis focuses on the impacts of steps to limit temperature rises, such as carbon prices or clean energy investment. Physical risks, on the other hand, have received less attention from investors. This is a mistake. Quantifying the extent to which individual companies and portfolios are exposed to physical climate risks is an important element of preparing for a more challenging future.

Without effective and transparent disclosure, the financial impacts of physical risks may not be priced correctly. In the long run, this will lead to significantly higher economic costs, making rapid adaptation with destabilizing effects on financial markets more likely.

Pricing in physical risks

When investment portfolios switch from high carbon to lower carbon investments – from fossil fuels to renewables – the move might simply result in different exposures and risks. For example, electricity generated by hydro power is the most widely used form of renewable energy, yet power output is vulnerable to climate change impacts such as changes in precipitation.

On the other hand, fossil fuel investments are vulnerable to increases in temperature and water shortages, which lead to loss of efficiency and output. These changes in risk materialize for an investor as soon as the portfolio is changed. We use catastrophe risk modeling to help investors understand these present-day risks. Then, going forward, we use climate change science to evaluate how these hazards will evolve over time, in line with changes to the portfolio.

On the other side, physical climate change impacts can also affect carbon emissions from investments. Again, we find this issue is not generally well understood. Maybe one of the clearest examples is in real estate investments. Energy demand for cooling buildings is, of course, closely related to temperature. As temperatures increase, cooling demand goes up – and, unless the building is cooled using renewable technologies, carbon emissions go up too.

Transmission channels and metrics that matter

To evaluate the risks effectively, we need to map how the metrics that matter to financial institutions – such as changes in asset value, value at risk and credit risk metrics – can be related back to present day and future hazard levels. We call these “climate transmission channels.”

We know that the physical impacts of climate hazards can affect different parts of companies’ value chains. We can analyze the financial impacts that flow on from those physical impacts – on companies’ revenues, capital expenditures and operating expenses and onwards to financial institutions themselves.

Many current approaches to providing financial results at the portfolio level overlook key stages of the transmission channel. The use of a large-scale risk analysis that doesn’t consider asset-level vulnerabilities, such as macroeconomic analysis that may show how increases in temperature can impact on sectors and on GDP, will always grossly oversimplify these impacts.

Challenges of quantification and how to handle uncertainty

We can quantify some physical impacts well, yet others are more challenging, requiring us to assess four levels of uncertainty:

1. A clear enough future: Reasonable confidence in a central forecast – and here, we can incorporate the physical impacts into a discounted cashflow model.
2. Alternative futures with probabilities: Future outcomes can be captured in discrete scenarios with probability weightings. Financial institutions can assess how alternative strategies will play out under each scenario.
3. Range of futures: Arguably where most types of future physical risks sit at the moment – this is where you don’t have a good sense of the distribution of outcomes but you can still think in quantitative terms to define a probable range and focus analysis on trigger events indicating a move toward one scenario or another.
4. Radical uncertainty: For issues that don’t lend themselves to quantification. Uncertainties of this nature will be familiar to investors, for example, climate change-driven geopolitical risk impacts on capital markets. Qualitative indicators can signal how various aspects about the future may evolve, and then you need to track those indicators. There are several aspects of physical risk that fit in here – how, for instance, physical risk may lead to geopolitical shocks through tensions over food prices or over water, which we are already seeing playing out in Asia. There is also the issue of litigation risks driven by physical risk – as we are seeing with PG&E in California, ultimately culminating with the utility declaring bankruptcy.

For a bank or an asset manager, that’s a critically important aspect. Looking in detail at specific companies helps to define the questions to be asked and also helps identify new investment opportunities in supporting companies as they adapt to physical risk. Being able to understand the impacts at the level of individual assets, supply chains, markets and customers, and intangible assets will help to identify those most at risk and to have focused conversations with companies about how they plan to manage the risks.