Physical Climate Risk for Investment Managers

At a glance…

• This summer we have witnessed extreme temperatures and devastating wildfires in Southern Europe, floods and landslides in Asia associated with a severe monsoon season, as well as widespread heatwaves in the US. Over the coming decades these extreme climate events are expected to increase in severity and/or frequency as global temperatures rise.
• For Investment management firms, the impact of extreme climate events are particularly pronounced for holdings in real assets such as real estate, infrastructure, utilities, and agriculture but these impacts can be complex to assess ¹.
• There is a growing need for Investment management firms to fully reflect the extent of these physical climate risks in investment management decision-making and climate disclosures. However, given that physical climate risk is still an emerging risk, there are various challenges associated with incorporating it into existing risk frameworks.
• In this blog we explore the need for investment firms to refine how material physical climate risks are managed, the challenges involved and key considerations for overcoming these.

The Financial Materiality of Physical Climate Risks

Despite global efforts to reduce carbon emissions and limit the impacts of climate change, some of these impacts are already being observed and are expected to intensify as global temperatures rise ² .

Physical climate risks can be quantified in terms of their adverse financial effects on real assets and are defined as either acute risks (e.g. climate events such as floods and hurricanes) or chronic risks (such as rising sea level). Investment management firms holding real assets are particularly exposed because the damage and disruption after extreme weather events can lead to a significant negative impact on asset valuations and viability.  An example of this was the California Wildfires in 2018, where several investment firms saw high-value properties and industrial complexes destroyed. Closer to home, the impacts of physical risk on the infrastructure sector are being recognised with the UK National Rail recently doubling their spending on weather resilience measures to adapt to climate risks ³ .

New disclosure requirements for physical climate risk

Investment management firms in the UK are now required to disclose their exposures to climate risks, both physical and transition, under the Taskforce on Climate Related Financial Disclosures (TCFD). This will be fully incorporated into the International Sustainability Standards Board (ISSB) climate disclosure standards (IFRS S2) from 2024 ⁴ .

However, there may be more work the sector needs to do. The UN Environment Programme Financial Initiative (UNEP FI), in its review of publicly available TCFD reports, stated concerns that physical climate risk may be a “blind spot” for financial institutions who are focussing on the risks associated with transitioning to a net zero economy (transition risks) rather than exposure to physical climate risks ⁵ . The implications of inadequately identifying exposures to physical climate risk go beyond disclosures. If this shortfall in reporting the risk is an indication of how the sector is assessing and taking into account their physical climate risks, then firms could be underestimating their exposure to unexpected financial consequences in the future.

Our observations on the challenges of assessing physical climate risks

While it has been highlighted by UNEP FI as a “blind spot” for financial services we observe a growing understanding of the challenges involved in modelling and assessing physical climate risk. In a Dear CEO letter on Climate Related financial risk in October 2022, the Prudential Regulatory Authority recognise that some firms are performing detailed analysis of asset loss by counterparties. That said, they also point to the inconsistency across the industry. There are challenges firms in the investment management sector should focus on overcoming when looking to strengthen their approach and capability assessing and using physical climate risk management. These challenges are as follows:

Forward looking data: Typically, physical climate risk assessments such as flood assessments are based on data from historical events.  Whilst a logical starting point, the lack of forward-looking data could systemically underestimate the impact of future flood events in a warmer climate.

Data granularity: Using inadequate location data granularity, prevents capturing an accurate view of physical climate risk at asset level.

Modelling uncertainty: There is a challenge across financial services in understanding and accounting for the uncertainty of future warming projections from climate models and how the impact could crystalise on the balance sheet ⁶ .

Reliance on Third Parties: Raw climate data requires expertise to extract and process into a format that is useful for investment managers. Due to these modelling complexities, firms tend to rely on third party vendors, which are growing in number. Often these models have opaque methodologies and vary significantly, making outcomes incomparable and selection challenging.

Cross dependencies: Most modelling approaches only capture the direct impact of physical climate risk and do not consider a broader scope outside real assets, such as impairment of critical infrastructure and supply chain disruption.  

Breadth of investments: If not properly overcome, these challenges can result in material underestimations of the physical climate risks investment firms are taking.

Key considerations for refining physical climate risk management

As firm’s understanding around physical climate risk impacts and modelling continues to evolve, we have set out initial steps which investment managers can take to assess, monitor, and manage their material exposure to physical climate risk:

• Extent of exposure: Assess your exposure to physical climate risk based on the assets that you manage. For example, you will need to identify the exposures for real-asset holdings as well as the as the exposures in the underlying business model of an equity holding. The values of both could be vulnerable to asset devaluation in the event of material physical risk exposures. This will influence the extent to which you need to build out your physical climate risk management framework.
• Risk Management Framework: Consider how to incorporate physical climate risk into the firm’s risk assessment, management, and appetite. This will allow a standardised approach for managing physical climate risk across an organisation, from acquisitions to portfolio monitoring.
• Modelling and data: Address the challenges outlined in the section above when approaching modelling of physical climate risk. In particular, ensure that adequate data granularity is available to model climate risks across various geographic regions and time horizons.
• Scenario and stress testing: Consider the most appropriate scenarios and time horizons to assess physical climate risk whilst accounting for modelling uncertainty with longer term horizons. Investment businesses that are part of a wider group that includes insurance may be able to benefit from capabilities used such as catastrophe modelling.
• Engage with issuers: Engage with stakeholders to collect granular data of physical assets and supply chains to understand wider exposures, and ensure they are actively managing their physical climate risk exposure.
• Outsourcing: External physical climate risk providers and experts can often provide effective and efficient way for firms to enhance capability. From sourcing specialist data and modelling to revising approach to assurance, third-party vendors can provide capabilities in this emerging and challenging area of risk management. This requires a clear understanding of the outputs and methodologies provided by the third parties.

Overall, physical climate risk management should be embedded into how investment firms manage risks relating to real assets. From overall investment strategy and risk appetite down into the quantitative risk assessment, investment decisions and disclosures. By doing so firms can better manage this emerging and important source of risk.

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References

1.  Understanding the Physical Risks Associated with Climate Change (garp.org)

2. AR6 Synthesis Report: Summary for Policymakers Headline Statements (ipcc.ch)

3. Network Rail doubles spending on adapting to climate risks | Financial Times (ft.com)

4. IFRS - IFRS Foundation welcomes culmination of TCFD work and transfer of TCFD monitoring responsibilities to ISSB from 2024

5. Physically-fit.pdf (unepfi.org)

6. Climate scenario models in financial services significantly underestimate climate risk · GreenFutures (exeter.ac.uk)