Physical risks

What Are Physical Risks?

Physical risks, within the context of climate finance, refer to the financial impacts stemming from changes in the Earth's climate system. These risks manifest as direct or indirect losses to assets, operations, or supply chains due to climate-related events and trends. They are a critical component of assessing overall environmental, social, and governance (ESG) considerations in investment and business strategy. Physical risks are typically categorized into two main types: acute and chronic. Acute physical risks are event-driven, resulting from severe weather events such as hurricanes, floods, wildfires, and droughts. Chronic physical risks, conversely, arise from longer-term shifts in climate patterns, including rising sea levels, sustained changes in precipitation, and persistent extreme temperatures. Both acute and chronic physical risks can lead to significant economic disruption and financial losses.

History and Origin

The concept of integrating climate-related risks, including physical risks, into financial analysis has gained prominence relatively recently, evolving alongside the increasing scientific understanding of climate change and its observable impacts. While weather-related losses have always been a factor in industries like insurance and real estate, the systematic categorization of these as "physical risks" within a broader financial risk management framework began to solidify in the early 21st century.

Key reports from intergovernmental bodies, such as those by the Intergovernmental Panel on Climate Change (IPCC), have been instrumental in establishing the scientific basis for understanding these threats. The IPCC's comprehensive Assessment Reports detail the global climate impacts, adaptation, and vulnerability, underlining how factors like increasing heatwaves, extensive wildfires, and extreme rainfall will worsen and feed into the economy, causing damages to physical assets and reduced productivity.⁷ Over time, central banks and financial regulators globally have recognized climate change as a significant threat to financial stability. For example, in its November 2020 Financial Stability Report, the U.S. Federal Reserve for the first time acknowledged the impact of climate risks, including acute and chronic hazards, on the financial system.⁶ This acknowledgment marked a crucial step in formalizing the integration of physical risks into macroeconomic and microeconomic risk assessments.

Key Takeaways

• Physical risks represent the financial consequences of climate change impacts on physical assets, operations, and economic activities.
• They are categorized into acute risks (event-driven, e.g., floods, wildfires) and chronic risks (long-term shifts, e.g., sea-level rise, chronic heat).
• Understanding and assessing physical risks is crucial for risk management in various sectors, including finance, real estate, and infrastructure.
• Regulatory bodies are increasingly requiring disclosure and consideration of physical risks to enhance market transparency and financial system resilience.
• These risks can lead to direct damages, business interruptions, supply chain disruptions, and impacts on asset valuation.

Interpreting Physical Risks

Interpreting physical risks involves assessing both the probability and potential severity of climate-related events and trends affecting specific assets, portfolios, or geographic regions. This assessment helps stakeholders understand their exposure to adverse climate impacts. For instance, a property located in a coastal floodplain faces a higher physical risk from sea-level rise and storm surges compared to an inland property. Similarly, agricultural businesses in regions prone to drought will interpret higher physical risks related to water scarcity and crop failure.

Financial institutions and corporations use various analytical tools, including scenario analysis and stress testing, to quantify and interpret potential financial losses from physical risks.⁵ The output might involve projected damages to infrastructure, estimates of business interruption costs, or potential declines in productivity. This interpretation aids in strategic planning, investment decisions, and the development of adaptation and mitigation strategies. Effective interpretation also requires considering the interconnectedness of risks, as climate events can have cascading effects across supply chains and industries.

Hypothetical Example

Consider "Green Valley Farms," a large agricultural enterprise primarily cultivating corn and soybeans in the Midwest. Green Valley Farms has historically relied on consistent rainfall patterns for successful harvests.

Scenario: Increased Frequency of Droughts

Due to changing climate patterns, the region experiences a significant increase in the frequency and severity of droughts over the next five to ten years.

Analysis of Physical Risk:

1. Direct Impact: Prolonged periods without rain lead to reduced crop yields. For example, in a severe drought year, Green Valley Farms' corn yield might drop by 30%, and soybean yield by 25%.
2. Indirect Impact (Operational): The farm may need to invest heavily in new irrigation systems, significantly increasing operating costs. Water rights could become more expensive and contentious, impacting future access.
3. Financial Impact:
   • Revenue Loss: With lower yields, Green Valley Farms' revenue from crop sales decreases substantially. If corn prices are \($5.00\) per bushel and normal yield is 200 bushels/acre, a 30% drop means a loss of \(0.30 \times 200 \text{ bushels/acre} \times $5.00/\text{bushel} = $300/\text{acre}\) in revenue.
   • Increased Costs: The capital expenditure for new irrigation, combined with higher water costs, further squeezes profit margins.
   • Credit Risk: Lenders to Green Valley Farms might reassess their loan terms or demand higher interest rates due to the increased default risk posed by the recurring physical risk.
   • Valuation Impact: The overall valuation of Green Valley Farms could decline as investors factor in the increased physical risks and their potential to erode future profitability.

This hypothetical example illustrates how a chronic physical risk (drought) can translate directly into financial losses and operational challenges for a business.

Practical Applications

Physical risks have widespread practical applications across various sectors of the economy and financial markets.

• Investment and Portfolio Management: Investors are increasingly evaluating how physical risks can impact the long-term viability and returns of their investments. This involves analyzing the geographic exposure of assets within a portfolio to acute events like hurricanes or chronic shifts like sea-level rise. For instance, asset managers may adjust their allocations to companies with significant physical assets in high-risk zones.
• Banking and Lending: Financial institutions assess physical risks when underwriting loans, particularly for mortgages, commercial real estate, and project finance. A property in a flood zone might face higher lending standards or require mandatory flood insurance. Banks also conduct stress testing to understand how widespread climate events could impact their loan portfolios and overall capital adequacy.
• Insurance Underwriting: The insurance industry is directly impacted by physical risks, as they are responsible for covering losses from extreme weather events. Actuaries use climate models to refine their pricing for property, casualty, and business interruption policies, often increasing premiums in areas with escalating physical risks.
• Corporate Strategy and Operations: Companies across all industries need to assess physical risks to their own operations, physical assets, and supply chains. This might involve relocating facilities, strengthening infrastructure, or diversifying suppliers to build resilience against climate impacts.
• Regulatory Compliance and Disclosure: Regulators worldwide are pushing for greater transparency on climate-related financial risks. The U.S. Securities and Exchange Commission (SEC), for example, has adopted rules requiring publicly traded companies to disclose material climate-related risks, including physical risks, in their financial filings.⁴ This move aims to provide investors with better information to make informed decisions.
• Urban Planning and Government Policy: Local and national governments use physical risk assessments to guide urban planning, infrastructure development, and disaster preparedness. This includes investing in flood defenses, revising building codes, and developing early warning systems.

Limitations and Criticisms

Despite their growing importance, the assessment and integration of physical risks into financial decision-making face several limitations and criticisms.

One primary challenge is the inherent uncertainty and long-term nature of climate projections. While climate science provides robust models, translating global climate trends into precise, localized financial impacts over relevant investment horizons remains complex. This can lead to difficulties in accurately pricing physical risks into asset prices or allocating capital effectively. Financial institutions often find challenges in obtaining sufficiently granular and consistent data for physical risk analysis, especially across diverse geographical regions and asset types.³

Another limitation is the "black box" nature of some climate risk assessment tools and methodologies. Financial actors have identified challenges such as a lack of transparency in underlying scenario assumptions, data sources, and the methodologies used by climate service providers.² This can hinder the ability of financial institutions to fully understand and integrate the risk assessments into their internal models and risk frameworks. Furthermore, there is a recognized lack of standardized industry models for embedding climate risk into broader enterprise risk management, leading to varied approaches and difficulties in comparability across firms.¹

Critics also point out that focusing solely on quantifiable physical damages might overlook broader societal and economic disruptions that are harder to monetize, such as mass migration, geopolitical instability, or the degradation of natural capital. These systemic impacts, while not always directly attributable to a single physical event, can nonetheless have profound financial repercussions.

Physical Risks vs. Transition Risks

Physical risks and transition risks are the two primary categories of climate-related financial risks, often discussed together but distinct in their nature. The key difference lies in their origin: physical risks stem from the physical impacts of climate change, while transition risks arise from the transition to a lower-carbon economy.

While distinct, physical and transition risks are interconnected. For instance, severe physical impacts (like widespread flooding) might accelerate regulatory action, thereby exacerbating transition risks (e.g., stricter building codes, higher carbon taxes). Conversely, a slow transition could lead to more severe physical impacts in the future.

FAQs

What is the primary difference between acute and chronic physical risks?

Acute physical risks are event-driven, referring to immediate and severe weather events like hurricanes, floods, or wildfires. Chronic physical risks, on the other hand, are long-term shifts in climate patterns, such as sustained rising temperatures, changing precipitation levels, or increasing sea levels. Both can cause significant financial impacts.

Why are physical risks important for investors?

Physical risks are crucial for investors because they can directly impact the profitability and value of companies and assets. Companies with significant physical assets located in regions vulnerable to climate impacts may face higher operational costs, potential asset damage, or business interruptions, all of which can erode investment returns. Investors need to understand these exposures to make informed decisions and build resilient portfolios.

How do companies assess their exposure to physical risks?

Companies assess their exposure to physical risks through various methods, including geospatial analysis to map assets against climate hazard data, engaging with climate scientists, and conducting scenario analysis or stress tests. They also analyze their supply chains for potential disruptions due to climate events. The goal is to quantify potential financial losses and identify vulnerabilities across their operations and investments.