An Analysis of Financial Losses and the Near-Term Physical Risks of Climate Change

Alicia White

Senior Product Manager, Climate Solutions

August 25, 2023: Please note this article has been updated since its original publication with revised figures and statistics.

Companies’ emissions are still grossly misaligned with reaching a 1.5-degree Celsius global warming scenario, which is contributing to climate change and worsening its physical impacts. The World Meteorological Organization has predicted that there is now a 66% chance we will pass the 1.5-degree Celsius global warming threshold between now and 2027.¹ With many areas of the world already facing record-setting heat waves and climate events, this additional warming could pose catastrophic risks for people, countries, and companies.

Additionally, this year is expected to be an El Nino year, which further increases the likelihood of rising temperatures generating more rainfall and extreme weather events. According to the National Oceanic and Atmospheric Administration (NOAA), an El Nino condition occurs when surface water in the equatorial Pacific becomes warmer than average and east winds are weaker than normal. El Nino conditions typically occur every three to five years and have impacts on local weather conditions around the world.² For example, in the southern United States, El Nino usually causes higher rainfall and destructive flooding. While the total impact of El Nino could end up costing the global economy US$3 trillion, it is likely to have disproportionate outcomes across sectors and regions.³

Investors need to know how the effects of the changing climate, along with El Nino, could affect their portfolio companies across different sectors and parts of the world. In this article, we use data from Morningstar Sustainalytics’ Physical Climate Risk Metrics – including productive capacity loss, high risk assets, and country contributions – to examine how physical climate risks are distributed across sectors and regions, bearing in mind the ways that El Nino could exacerbate these risks in the short-term (see Table 1). We focus our analysis on an RCP2.6 climate change scenario,⁴ which is aligned to keeping global temperature rise below 2 degrees Celsius by 2100 and is most similar to near-term conditions.

Table 1. Core Metrics Assessed By Physical Climate Risk Metrics

Metric	Definition
High Risk Assets	The portion of a company’s assets at high risk for direct infrastructure damage. A higher value is worse, as it indicates a higher percentage of a company’s physical assets that have significant exposure to direct infrastructure damage.
Asset Damage Risk	The relative vulnerability to direct infrastructure damage. A worse score on this metric means a company can expect a higher degree of direct infrastructure damage.
Productive Capacity Loss	The risk that asset operations will be interrupted due to physical hazards. A worse score on this metric means a company will experience more days where their operations are impeded by physical hazards.
Local Critical Infrastructure Risk	The risk that critical infrastructure surrounding a company’s assets may fail due to physical hazards. A worse score indicates that a company is indirectly exposed to risk, due to critical infrastructure failures such as utility stations, supply roads, etc.
Regional Risk	Assesses the average risk of damage to the built environment in the region where the company’s assets are located. A worse score on this metric indicates a company is operating in regions with above average risk.

^{Source: Morningstar Sustainalytics. For informational purposes only.}

The Sectors Most Vulnerable to Physical Climate Risks

While no sector or region is immune to the effects of climate change, certain sectors are more exposed to these risks than others. Companies in the energy, industrials and utilities sectors have the highest average loss ratios due to direct and indirect physical climate risks under an RCP2.6 scenario (see Figure 1 below). This indicates that for the average company in each of these sectors, their expected cumulative financial losses due to physical climate risk factors are equivalent to 4.5% of their operating cash flow. For companies in these sectors especially, the medium and long-term consequences of physical climate risk will be material to their financial and capital expenditure decisions.

Figure 1: Average Ratio of Direct and Indirect Losses in Comparison to Operating Cash Flows in a ~2°C World (RCP2.6)

^{Source: Morningstar Sustainalytics. For informational purposes only.}

Looking at the near term, we know that El Nino weather patterns can exacerbate certain physical hazards such as flooding and extreme heat. What does Morningstar Sustainalytics’ Physical Climate Risk Metrics tell us about how companies in these sectors may be affected by these hazards associated with El Nino?

A Closer Look at Physical Climate Risks in the Utilities Sector

Even if global temperature rise stays below 2 degrees Celsius, companies in the utilities sectors are still vulnerable to direct and indirect physical climate risks, which means the water, electricity and heating and cooling capacity for populations globally are also at risk. Within the utilities sector, on average the physical hazards contributing the most to asset damage risk are flooding and coastal inundation. Under an RCP2.6 scenario, in 2027 the average utilities company in the Physical Climate Risk Metrics universe is expected to see 50% of their asset damage risk come from flooding, and 25% from coastal inundation. In total, 75% of the average utilities company’s risk will come from an increase in water, whether on land or on the coast.

Figure 2: Contribution to Asset Damage by Hazard, Utilities Sector, 2027 (RCP2.6)

^{Source: Morningstar Sustainalytics. For informational purposes only.}

In 2027, the utilities sector is also expected to have the highest percentage of assets at high risk (see Figure 2 below) compared to other sectors. These high-risk assets are expected to incur damages greater than 1% of their replacement value, which means companies may face challenges and increased costs to insure these assets.

Figure 3: Average Percentage of Assets at High Risk in 2027 by Sector (RCP2.6)

^{Source: Morningstar Sustainalytics. For informational purposes only.}

Analysis of Country Contribution to Physical Climate Risks for Vulnerable Sectors

The direct impacts of physical climate change on companies’ assets can be assessed in two ways – as asset damage risk, which describes the direct physical damage to an asset, and as productive capacity loss, which describes the losses in productivity from forced closures or damage. For both metrics, it is useful to understand how a company’s assets are affected across different locations, especially for companies with global assets.

Within the universe of companies for this analysis, assets in the United States contribute the most risk to overall average physical climate risks. The same holds true in 2027 under an RCP2.6 scenario when assessing overall average productive capacity loss for the Physical Climate Risk Metrics universe (see Figure 4). Thus, companies’ assets in the U.S. are contributing the most to the average overall risk of climate-induced productive capacity loss, which has implications for all sectors as companies develop strategies and allocate capital to manage and mitigate risks.

This counters a prevailing belief that the Global North will be spared significant impacts of climate change. While it is true that many communities in the Global South are disproportionately affected by the changing climate, despite emitting fewer GHGs, companies with assets in the Global North, including the U.S., will also be heavily impacted by the physical impacts of climate change.

Figure 4: Leading Country Contributors to Productive Capacity Loss Across All Sectors in 2027 (RCP2.6)

^{Source: Morningstar Sustainalytics. For informational purposes only.}

The utilities sector also has a significant amount of its risk coming from assets in the United States. For one -fifth of the assessed utilities companies, at least 50% of their global high-risk assets are in the U.S., while another third of companies have at least 50% of their high-risk assets located in Asia Pacific, including China, India, Hong Kong, and Japan (see Figure 5).

Given that many areas in these regions are prone to flooding, and the upcoming El Nino cycle will probably exacerbate such flooding, assets in these countries are likely to experience damage in the coming years. Utilities and their investors should assess mitigation and adaptation strategies for assets in these countries.

Figure 5: Leading Country Contributors to High-Risk Assets Within the Utilities Sector in 2027 (RCP2.6)

^{Source: Morningstar Sustainalytics. For informational purposes only.}

Actions for Investors Managing Near-Term Physical Climate Risks

To manage their exposure to physical climate risks, investors first need to assess and analyze how physical climate risks may impact their portfolio. They need to be able to answer key questions, like:

Which hazards and geographies drive their portfolios’ climate risks?
How do their portfolio companies’ physical climate risks compare to their peers?
What proportion of their assets are at high risk?

Answering these questions will also help investors adequately respond to voluntary and mandatory reporting obligations. Investors can also use this information to engage with portfolio companies and drive adaptation and mitigation measures that can lower their exposure to financial impacts.

Morningstar Sustainalytics can help investors and issuers understand their potential exposure to physical climate risks now and in the future. Learn more about our Climate Solutions or get in touch with our team.

References

McGrath, M. 2023. “Global Warming Set to Break Key 1.5C Limit for the First Time.” BBC. May 17, 2023. https://www.bbc.com/news/science-environment-65602293
National Oceanic and Atmospheric Administration. 2015. “El Nino and La Nina.” July 1, 2015. https://www.noaa.gov/education/resource-collections/weather-atmosphere/el-nino.
Teirstein, Z. 2023. “El Nino Could Cost the Global Economy $3 Trillion.” Grist. May 18, 2023. https://grist.org/climate/el-nino-could-cost-global-economy-3-trillion/
For the purposes of this analysis, RCP2.6 serves as a proxy for the conditions anticipated due to current emissions and a temperature rise of nearly 1.5 degrees.

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