Physical climate risks present material risks to companies, financial institutions, and investors. The negative physical impacts of climate change are already being felt by communities and corporations globally and are likely to get worse in the coming years. In some regions, physical climate risk could permanently reduce GDP by up to 25% by 2050.1 According to a 2020 study by McKinsey, in Ho Chi Minh City direct infrastructure asset damage from a 100-year flood could rise from between US$200 and US$300 million today to US$500 million to US$1 billion in 2050.2 The knock-on costs of such an event to the economy could rise from between US$100 and US$400 million to between US$1.5 billion and US$8.5 billion.3
This looming threat means it is imperative for investors to forecast the asset-level effects of climate change on companies in a granular and sophisticated way. Not only is it in investors’ financial interests to incorporate considerations of physical climate risk into portfolio management, but it is also increasingly required by governments and supervisory agencies. Government entities like the Securities and Exchange Commission in the U.S. and the U.K.’s Financial Conduct Authority are considering, or have enacted, mandatory disclosure and voluntary reporting requirements and recommendations to gain insight into the material risks that climate change poses to economies and financial systems.
To manage and mitigate the physical risks of climate change to their portfolios and meet a growing list of climate-focused reporting requirements, portfolio managers should be able to answer these six questions.
1. How are your portfolio’s assets impacted by physical climate risks?
Companies are at financial risk from climate change both because of direct infrastructure damage as well as productivity disruptions caused by failures at their operations. These two types of physical impacts, while both disruptive, affect different areas of a company’s financial health. Direct infrastructure damage may lower the value of a company’s assets or property, plant and equipment (PP&E), while productivity disruptions are more likely to impact revenues. Investors can use this information to ensure their portfolio is not overly exposed to certain types of physical climate risks.
Consequences of direct infrastructure damage vary across regions and companies. For instance, a study by XDI found that even within the Asia-Pacific region, the degree of risk differs significantly between individual markets.4 XDI’s study indicates that the ASX 200, the Hang Seng and the Straits Times Index present the greatest risk of damage due to extreme weather events and resulting higher insurance costs, whilst the Nikkei 225 holds most risk from extreme weather impacts on physical assets.
While productive capacity loss similarly varies across regions, results from the same XDI analysis show some companies with productivity losses already approaching 3%. These effects will be higher still at the individual physical asset level. For a company with a 20% profit margin, 3% loss of general revenue could translate to a 15% reduction in profits, even before considering elevated insurance costs.
2. What element of climate change is the most dangerous to your portfolios?
Climate change is exacerbating existing physical hazards in addition to bringing new hazards to regions that have not traditionally experienced them. Extreme heat is just one result of global temperature rise. Rising sea levels are also a well-known concern, but wind patterns, soil stability, wildfires, and freezing-level temperatures are all affected. Depending on where a company’s assets are located, certain hazards will be of greater concern.
A 2020 McKinsey study found that by 2050, up to 185,000 airline passengers may be grounded per year due to extreme heat, approximately 23 times more than today.5 These disruptions will have compounding effects; grounded flights will have repercussions on transportation infrastructure, the hospitality industry, tourism, immigration, all outside of the direct impacts to the airline industry itself. Investors whose portfolios include industries related to aviation will likely experience these negative impacts.
By having a strong understanding of the physical hazards of climate change and the relationship between those hazards and the operations and assets in a portfolio, investors can identify problem areas and address them.
3. What proportion of assets in your portfolio(s) are at risk due to climate change?
By 2100, the proportion of assets considered at “high risk” of damage is expected to double, setting many companies up for inordinately expensive repairs or replacements. This indicates that for companies, the impacts of physical climate risks are not isolated to a few key assets, but rather will likely encompass a growing number of their assets. And for this growing number of high-risk assets, companies cannot guarantee that their operations can be reliably decommissioned to lower risk assets. An asset impacted by a heat wave may be able to shift its supplies and operations to another asset, but the same asset experiencing a flood may result in stranded or destroyed raw materials. Therefore, assets at high risk will face interruptions in operations and loss of revenue at unpredictable intervals and severity.
In the short term, investors can use an assessment of high-risk assets to identify issuers who are more likely to divert their cash on hand to major capital expenditures instead of to profit and additional investment.
In the long term, property and casualty insurers will cast an eye towards the insurability of these assets. Where insurers may typically base their modeling on historical data, those who use forward-looking forecasting, including climate modeling, will have to consider the following issues, as posited by McKinsey:6
“As the frequency and severity of [climate] events—formerly thought to be low probability—increase, so do changes to the balance sheet, including higher capital requirements for reinsurance consumption.
Investors, regulators, and society will increase pressure on the industry to respond to climate risk as large portions of the economy and society continue to be affected.
Some historically stable premium and profit pools will shrink, and possibly disappear, in places and industries that are exposed to climate risk while assets will become harder to insure.”
4. Which locations or geographies are driving your portfolios’ physical climate risks?
In 2022, the physical dangers of climate change have taken over the headlines around the world. Heatwaves in the United Kingdom, North America, and Japan, flooding in Pakistan, and droughts in Europe and China have endangered the lives and livelihoods of millions of people. Investors need geographically differentiated physical climate risk metrics to assess companies’ ability to adapt to and mitigate risks based on their unique geographic locations.
In analyzing the U.K.’s July heatwave, scientists from South Africa, Germany, France, Switzerland, New Zealand, Denmark, the U.S, and the U.K determined that the heat wave was made ten times more likely due to changes in global climate.7 Further, temperatures tracked in places like Cranwell, Lincolnshire exceeded temperatures of a 1-in-1,500-year heat event.
Understanding the shape that physical climate risk can take, along with the location of your portfolio’s physical assets, can bring the impacts on your investments into focus. In the U.K., July’s severe heat may not have resulted in permanent damage to facilities, but it did lead to Google and Oracle shutting down their data centers temporarily.8 In this instance, Google and Oracle were likely able to divert server traffic to other server locations – however as heat waves become more prevalent throughout the world, this course of action may become more difficult.
5. How do your portfolios’ companies compare to peers?
Similar companies can have different physical climate risk profiles. Knowing how each company compares to others in your investment universe, as well as against those in their subindustry, can help you make better decisions about how to structure your portfolios. No companies are immune to climate change, so a portfolio that actively measures and manages its physical climate risks has the potential to outperform its peers.
6. What is your plan to fulfill climate reporting obligations?
Institutional investors are under increasing pressure to assess the impacts of physical climate risk on their portfolio companies. Regulatory and voluntary initiatives such as the EU Action Plan, TCFD, and PRI are driving the need for investors to disclose how they are managing the risks posed by climate change. Collecting the data and metrics needed to fulfill these requirements can be challenging, especially for investors with large portfolios. Physical Climate Risk Metrics can help investors aggregate direct risk data across more than 12 million assets and 12,000 companies, making it easier to fulfill reporting requirements. As part of the planned enhancement coming in early 2023, Physical Climate Risk Metrics will be adding indirect risk metrics and financial loss calculations, to provide an assessment of the full business value chain as recommended by TCFD and other frameworks.
1 Swiss Re Institute (2021). “The economics of climate change: no action not an option,” accessed (25.08.22) at: https://www.swissre.com/dam/jcr:e73ee7c3-7f83-4c17-a2b8-8ef23a8d3312/swiss-re-institute-expertise-publication-economics-of-climate-change.pdf.
2 Woetzel, J., Pinner, D., Samandari, H., Engel, H., Krishnan, M., and Cooper, P. (2020). “Can coastal cities turn the tide on rising flood risk?” McKinsey Sustainability, accessed (25.08.22) at: https://www.mckinsey.com/business-functions/sustainability/our-insights/can-coastal-cities-turn-the-tide-on-rising-flood-risk.
3 Woetzel, J., Pinner, D., Samandari, H., Engel, H., Krishnan, M., Boland, B., and Powis, C. (2020). “Climate risk and response: Physical hazards and socioeconomic impacts,” McKinsey Sustainability, accessed (25.08.22) at: https://www.mckinsey.com/business-functions/sustainability/our-insights/climate-risk-and-response-physical-hazards-and-socioeconomic-impacts.
4 XDI (2021). “XDI 1000 reveals widespread corporate exposure to financial impacts of physical climate risk,” XDI Benchmark Series – Insights, accessed (25.08.22) at: https://xdi.systems/xdi-1000-insights/.
5 Woetzel, J., Pinner, D., Samandari, H., Engel, H., Krishnan, M., Boland, B., Cooper, P., and Ruby, B. (2020). “Will infrastructure bend or break under climate stress?” McKinsey Sustainability, accessed (25.08.22) at: https://www.mckinsey.com/business-functions/sustainability/our-insights/will-infrastructure-bend-or-break-under-climate-stress.
6 Grimaldi, A., Javanmardian, K., Pinner, D., Samandari, H., and Strovink, K. (2020). “Climate change and P&C insurance: The threat and opportunity,” McKinsey & Co, accessed (25.08.22) at: https://www.mckinsey.com/industries/financial-services/our-insights/climate-change-and-p-and-c-insurance-the-threat-and-opportunity.
7 World Weather Attribution (2022). “Without human-caused climate change temperatures of 40C in the uK would have been extremely unlikely,” accessed (25.08.22) at: https://www.worldweatherattribution.org/without-human-caused-climate-change-temperatures-of-40c-in-the-uk-would-have-been-extremely-unlikely/.
8 Vallance, C. (2022). “Heatwave forced Google and Oracle to shut down computers,” BBC.com accessed (25.08.22) at: https://www.bbc.com/news/technology-62202125.
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