Physical risk

What Is Physical Risk?

Physical risk refers to the potential financial losses and disruptions that businesses, investors, and economies may incur due to the direct impacts of climate change. It is a critical component of financial risk management that encompasses both acute and chronic hazards. Acute physical risks are event-driven, resulting from severe weather events like hurricanes, floods, wildfires, and extreme temperatures. Chronic physical risks, on the other hand, stem from longer-term shifts in climate patterns, such as rising sea levels, prolonged droughts, and changes in precipitation. Understanding and managing physical risk is increasingly vital for maintaining financial stability and ensuring long-term economic resilience.

History and Origin

While natural disasters have always posed threats, the concept of physical risk as a distinct category within financial analysis gained prominence with the growing recognition of anthropogenic climate change and its escalating impacts. A significant moment in the formalization of physical risk disclosure came with the establishment of the Task Force on Climate-related Financial Disclosures (TCFD) in 2015 by the Financial Stability Board (FSB). The TCFD published its recommendations in 2017, identifying climate-related risks as falling into two main categories: physical risks and transition risks. This framework provided a standardized approach for organizations to assess and report on these risks, prompting greater scrutiny from regulators and investors globally. The TCFD's recommendations, updated in 2021, have been widely adopted and underpin many mandatory reporting requirements worldwide, including those in the United States⁸, ⁹.

Key Takeaways

• Physical risk involves financial losses and disruptions from both short-term extreme weather events (acute risks) and long-term climate shifts (chronic risks).
• It impacts various aspects of a business, including assets, operations, supply chains, and revenues.
• Regulatory bodies like the SEC, along with central banks and international organizations, are increasingly requiring or recommending disclosure and management of physical risk.
• Effective risk management of physical risk involves identifying exposures, assessing vulnerabilities, and implementing adaptation and mitigation strategies.
• Failure to address physical risk can lead to significant economic impact, affecting asset values, insurance availability, and overall financial performance.

Interpreting Physical Risk

Interpreting physical risk involves evaluating the potential severity and likelihood of climate-related hazards affecting an entity's assets, operations, and financial performance. This assessment typically considers the geographic location of assets and their vulnerability to specific climate events or long-term trends. For instance, a coastal manufacturing plant faces high physical risk from rising sea levels and storm surges (chronic and acute), while agricultural businesses might face risks from drought or extreme temperatures.

The interpretation also differentiates between the direct impacts, such as property damage, and indirect impacts, like supply chain disruptions or increased operational costs. Organizations often use scenario analysis to model potential future climate conditions and their implications, helping them understand the resilience of their strategy under various physical risk exposures. This comprehensive approach allows for better-informed strategic planning and capital allocation decisions.

Hypothetical Example

Consider "Sunshine Resorts," a hypothetical hotel chain with numerous properties along coastal regions. A key physical risk for Sunshine Resorts is the increasing frequency and intensity of hurricanes, which represent an acute risk. In a scenario analysis, the company might model the financial impact of a Category 4 hurricane making landfall every five years, compared to every ten years previously.

For a specific resort located in Florida, this analysis would factor in potential damages to physical structures, loss of revenue due to closures, and increased insurance premiums. If a typical Category 4 hurricane causes $50 million in damage and results in three months of closure, the company's financial planning must account for these potential liabilities. Furthermore, the chronic risk of sea level rise might necessitate long-term investments in sea walls or property elevation for its real estate holdings. By quantifying these impacts, Sunshine Resorts can assess its overall exposure to physical risk and determine appropriate adaptation measures.

Practical Applications

Physical risk manifests across various sectors and requires proactive management:

• Corporate Strategy: Businesses integrate physical risk into their long-term strategic planning, considering the resilience of their supply chain and the location of new investments. For example, a global manufacturer might diversify its production facilities to reduce reliance on regions highly susceptible to extreme weather.
• Investment Decisions: Portfolio management now often includes assessing the physical risk exposure of assets. Investors might favor companies with robust climate adaptation plans or those located in less vulnerable areas to protect asset valuation.
• Real Estate and Infrastructure: Property developers and owners analyze physical risk, such as flood risk or wildfire exposure, to inform design, construction, and pricing. This includes evaluating the long-term viability of investments in vulnerable coastal areas or drought-prone regions.
• Insurance Industry: Insurers are on the front lines of physical risk, facing higher payouts for claims related to extreme weather events. This directly impacts premium pricing, coverage availability, and the solvency of insurance providers.
• Financial Regulation: Regulators are increasingly mandating or recommending disclosures related to physical risk. For instance, the U.S. Securities and Exchange Commission (SEC) has adopted rules requiring public companies to disclose material climate-related risks, including physical risks such as hurricanes, floods, droughts, and wildfires, and their financial impacts⁶, ⁷. Similarly, the International Monetary Fund (IMF) and the Federal Reserve are assessing the systemic financial stability implications of physical climate risks on banking and financial systems⁴, ⁵.

Limitations and Criticisms

While the assessment of physical risk is crucial, it faces several limitations. A primary challenge is the inherent uncertainty in climate projections over long time horizons, which complicates precise risk quantification and future impact forecasting³. The exact timing, intensity, and location of future extreme weather events are difficult to predict, making granular financial modeling complex.

Furthermore, integrating physical risk into traditional financial models can be challenging due to data limitations and the non-linear nature of climate impacts. Critics also point out that companies may struggle to accurately attribute expenditures and losses directly to climate-related physical risk versus routine operational or maintenance costs, potentially leading to inconsistent or incomplete disclosure². There's also a concern that focusing too heavily on physical risk might divert resources or attention from necessary investments in climate mitigation, which could reduce future physical risks. Despite these challenges, the continued development of corporate governance frameworks and data analytics aims to improve the robustness of physical risk assessments.

Physical Risk vs. Transition Risk

Physical risk and transition risk are both categories of climate-related financial risk, but they arise from different sources. Physical risk stems from the direct physical impacts of climate change, such as damage to property or disruptions to operations caused by extreme weather events (e.g., floods, wildfires) or long-term climatic shifts (e.g., sea level rise, chronic heat).

In contrast, transition risk arises from the process of adjusting to a lower-carbon economy. This includes policy changes (e.g., carbon taxes, new regulations), technological advancements (e.g., renewable energy adoption, efficiency improvements), market shifts (e.g., changes in consumer preferences, demand for sustainable products), and reputational factors. For example, a fossil fuel company faces significant transition risk due to stricter emissions regulations and decreasing demand for its products, whereas a coastal real estate developer faces physical risk from rising sea levels. While distinct, these two categories of risk are interconnected, as efforts to mitigate transition risks (e.g., reducing emissions) aim to lessen future physical risks.

FAQs

What are examples of acute physical risks?

Acute risks are event-driven and include severe weather events such as hurricanes, floods, tornadoes, wildfires, and extreme heatwaves. These events typically cause immediate, observable damage or disruption.¹

What are examples of chronic physical risks?

Chronic risks result from longer-term shifts in climate patterns. Examples include sustained changes in precipitation (leading to droughts or water scarcity), rising average temperatures, sea level rise, and ocean acidification.

How do companies manage physical risk?

Companies manage physical risk through various strategies, including enhancing the resilience of infrastructure, relocating vulnerable assets, diversifying supply chains, purchasing appropriate insurance, and integrating climate-related considerations into risk management and strategic planning processes. They may also use stress testing and scenario analysis to evaluate potential impacts.