August 25, 2023: Please note: This article has been updated with revised figures and statistics since its original publication.
As the physical impacts of climate change increase in severity and frequency, awareness of how they impact individuals, businesses and financial institutions is becoming more mainstream. While there are some data and tools available to help governments and individuals assess their exposure to physical climate risks,1 institutional investors face unique challenges in making informed decisions about physical climate risks. They must assess physical climate risk on a global scale, and they must consider a wide range of mechanisms through which physical climate risks impact their investments across the value chain. Additionally, investors must manage and assess risks on different timescales depending on how their investments are structured.
The consequences of physical climate risks can place significant pressure on corporate finances. The cost of damage to physical assets, along with lost revenue, will negatively impact the bottom line. The average (average) value for each sector shows that many sectors are vulnerable to significant losses from physical climate risks. In particular, the average energy companies in the product universe could experience cumulative direct losses of more than $1.6 billion between now and 2050 in a greenhouse scenario (RCP8.5) in which global emissions continue to rise throughout the century. Investors should research their portfolio companies to understand what impacts they may have.
Figure 1: Average cumulative direct and indirect losses in a ‘hot house’ world scenario by 2050 (RCP8.5)
Source: Morningstar Sustainalytics. For informational purposes only.
Direct and indirect physical climate risks defined
Material financial consequences of physical climate risks can be divided into direct and indirect risks. Direct physical climate risks include things like depreciation costs and loss of productivity. For example, a grain processing plant damaged by floods and winds will incur costs to repair the building and equipment and lose revenue due to the associated downtime.
Indirect physical climate impacts can disrupt the supply and demand of the business value chain. In the example of the grain processing plant, if the plant itself is not damaged by flooding, damage to nearby railroads and highways on which the plant depends to receive and export its inputs and outputs would negatively impact operating capacity. Both direct and indirect risks cover important parts of the corporate value chain for portfolio companies, and reporting frameworks such as the Taskforce for Climate-related Financial Disclosure (TCFD) have recognized the importance of capturing this full spectrum of risks.
Potential losses due to direct physical climate risks
Losses from direct physical climate risks include losses arising from the impact on assets a company owns or leases. These losses can manifest in the form of loss of property value due to damage to a physical asset, or loss of revenue due to interruptions in production capacity.
For example, the average information technology company in the Physical Climate Risk Metrics product universe will only lose approximately 1.7% of operating cash flow due to direct and indirect risks between now and 2050 (Total Loss Ratio of 0.017), while the average energy company in the product universe can be expected to lose approximately 5.2% of operating cash flow to these risks over the same period (Total Loss Ratio of 0.052) (see Figure 2 below).
Figure 2: Average direct and indirect loss ratios by sector in a ‘hot house’ world scenario (RCP8.5)
Source: Morningstar Sustainalytics. For informational purposes only.
*Note that the Indirect Loss Ratio covers risks to local critical infrastructure surrounding an asset, but does not yet include risks to a company’s entire supply chain.
Consequences of indirect physical climate risks
While direct physical climate risks are difficult to quantify, indirect physical climate risks are even more so. Indirect physical climate risks affect the services and resources a company uses but does not own or control. These risks mainly affect the production capacity of a company’s assets and can affect both upstream and downstream activities. Damage to critical infrastructure in the region surrounding an asset, such as an electrical substation or a water treatment plant, can hinder a company’s ability to operate effectively.
Other examples of how indirect risks impact businesses include the impact on the global supply chain and on regions and countries. Increasingly interconnected global supply chains and the common use of just-in-time production systems make companies vulnerable to disruptions in manufacturing and shipping around the world. Companies operating in regions and countries harmed by physical hazards are also exposed to volatility in supply and demand, and disruptions to their workforce.
As with Scope 3 greenhouse gas emissions, investors need ways to assess the risks to a company across the business value chain. By studying a company’s exposure to indirect physical climate risks, investors can understand how external forces can impact a company in the regions in which it operates.
For example, in 2021, floods in British Columbia, Canada washed away rail lines, causing grain producers, transporters and processors to experience disruptions in access to supply chains.2 That same year, the Caldor Fire in California was estimated to cost tens of millions of dollars in lost economic activity within a single county due to smoke, evacuation and supply chain disruptions – even though no buildings were damaged in that county.3 In 2022, heat waves in the UK caused cooling systems in Google’s data centers to fail, impacting customers across Europe.4 These types of risks, among others, will continue to increase in severity and frequency as climate change worsens.
Why investors should pay attention to increasing physical climate risks
Countries, exchanges and industry groups are adopting regulations that require companies and institutional investors to report and disclose their exposure to physical climate risks in accordance with the TCFD framework. As these jurisdictions expand the available data on physical climate risks, investors will be able to make more sophisticated decisions to manage their exposure to these risks, similar to how available data on greenhouse gas emissions enables better decision-making around transition risks.
Expectations on how investors should integrate physical climate data into risk management are also becoming increasingly sophisticated. This is perhaps most evident in the increasing granularity of risk management and business strategy disclosures in regulations such as the European Banking Authority’s Pillar 3 disclosures and the UK Financial Conduct Authority’s TCFD reporting requirements. A working document of the European Central Bank5 shows that markets are already starting to price in physical climate risks, albeit at the sector level and not at the issuer level. By using more extensive bottom-up information about companies, investors can use data on physical climate risks as a competitive advantage in a challenging market.
View our physical climate risk statistics videos to learn more about the insights these metrics can give investors into the financial resilience of their portfolio companies.
1 See https://riskfactor.com/
2 Atkins, E. and McGee, N. 2021. “Canada faces grain backlogs, with BC freight halted after flooding.” November 21, 2021. The Globe and Mail. https://www.theglobeandmail.com/business/article-canada-faces-grain-backlog-with-freight-halted-through-bc-after/.
3 Gedye, G. 2021. “How Much Do Wildfires Really Cost California’s Economy?” October 11, 2021. CalMatters. https://calmatters.org/economy/2021/10/california-wildfires-economic-impact/.
4 Swinhoe, D. 2022. “Google data center outage in London during heat wave caused by ‘simultaneous failure of multiple, redundant cooling systems.’” August 2, 2022. DataCenterDynamics.com. https://www.datacenterdynamics.com/en/news/googles-london-data-center-outage-during-heatwave-caused-by-simultaneous-failure-of-multiple-redundant-cooling-systems/.
5 Bua, G., Kapp, D., Ramella, F, and Rognone, L. 2022. “Transition versus pricing of physical climate risks in European financial markets: a text-based approach.” July 2022. European Central Bank Working Paper Series. https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2677~9fc49e8300.en.pdf.