Capturing the Direct and Indirect Risks of Physical Climate Change in Investment Portfolios

Despite these complexities, institutional investors need clear insights into how physical climate change may impact their investments, both today and in the future. As with other risk channels, such as market and regulatory risks, investors require granular data to be able to make informed financial decisions and remain competitive. And they need to translate physical climate risks into an assessment of the resulting material financial impact on their portfolio companies.

Impacts of Physical Climate Risks on Companies

The impacts of physical climate risks can create a significant drain on company finances. The costs of damage to physical assets, along with lost revenue, will negatively affect a company’s bottom line. The average (mean) value for each sector shows that many are vulnerable to significant losses from physical climate risks. In particular, the average energy companies in the product universe may experience cumulative direct losses of over US$1.6 billion between now and 2050 in a hot house world scenario (RCP8.5) where global emissions continue to rise throughout the century. Investors should examine their portfolio companies to understand how they may be affected.   

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 impacts of physical climate risks can be categorized into direct and indirect risks. Direct physical climate risks include things like impairment costs and productivity loss. For example, a grain processing plant that is damaged by flooding and wind will incur costs from repairing the building and equipment, as well as lost revenue from the associated downtime. 

Potential Losses Due to Direct Physical Climate Risks

Losses from direct physical climate risks include those resulting from impacts to assets that a company owns or leases. These losses can manifest themselves as either lost property values due to damage sustained to a physical asset, or lost revenue resulting from interruptions in productive capacity. 

For example, the average information technology company in the Physical Climate Risk Metrics product universe will only lose about 1.7% of operating cash flow between now and 2050 due to direct and indirect risks (Total Loss Ratio of 0.017), while the average energy company in the product universe can expect to lose approximately 5.2% of operating cashflow on these risks during 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 Indirect Loss Ratio covers the risks to local critical infrastructure surrounding an asset but does not yet include risks to a company’s full supply chain.} 

Impacts 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 primarily impact the productive capacity of a company’s assets and can affect both upstream and downstream operations. Damage to critical infrastructure in the region surrounding an asset, such as an electric substation or water purification plant, for example, could impede a company’s ability to operate effectively. 

Similar to scope 3 GHG 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 affect a company in the regions in which they operate.

Why Investors Need to Pay Attention Mounting Physical Climate Risks

Countries, stock exchanges and industry groups are adopting regulations that require companies and institutional investors to report and disclose their exposure to physical climate risks in alignment with the TCFD’s framework. As these jurisdictions expand the data that is available on physical climate risks, investors will be able to make more sophisticated decisions to manage their exposure to these risks, similar to how available GHG emissions data allows better decision-making around transition risks.

Watch our Physical Climate Risk Metrics videos to learn more about the insights these metrics can give investors into the financial resiliency of their portfolio companies.

References

^{1 See https://riskfactor.com/}

^{2  Atkins, E. and McGee, N. 2021. “Canada faces grain backlog with freight halted through B.C. 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’s London data center outage during heatwave 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 physical climate risk pricing 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.}