The ability of decision makers to assess climate-related physical risk to companies’ operations is key to the reallocation of capital to mitigation and adaptation efforts that can limit such risks and their financial implications. However, a lack of information – about individual factories, for example – can lead to major errors of judgment.
A recent study details the first comprehensive method for assessing asset-level climate financial risk. It takes into account the interplay of long-term climate-related impacts, extreme climate events, and firms’ revenues across business lines and locations.
This article is part of our series on current academic research into a range of sustainability-related investment topics. The papers discussed were presented at the latest annual Global Research Alliance for Sustainable Investment and Finance conference. We believe in science-led sustainable investment. Partnering with academic researchers can add value since thorough research helps us to grasp the scope of climate change and biodiversity loss, to quantify risk, and to develop fit-for-purpose solutions. This is why we sponsor GRASFI’s annual conference and share relevant scientific findings with investors, clients and the wider asset management industry on our websites.
The paper, “Asset-level climate physical risk assessment is key for adaptation finance”[1], describes a way of assessing physical climate risk that connects asset-level (financial, extra-financial and climate) information to firms’ business lines, macroeconomic dynamics, financial valuation and investor risk.
The methodology combines the acute and chronic impacts of climate change, taking into account tail risk scenarios, and translates them into quantifiable information about financial risk for investors. Data on shocks suffered by physical assets is used to adjust the valuation of a company’s equity, using a climate dividend discount model.
The approach helps to limit the underestimation of economic and financial losses from climate-related physical risks, which is crucial to support better decision-making for adaptation finance.
Climate already affecting financial stability
Assessing climate-related financial risk is high on the agenda of researchers, investors and financial supervisors. Research increasingly shows that the economic and financial implications of physical climate risk and transition risk can be large enough to affect financial stability.
Climate-related hazards (e.g., hurricanes, droughts) already affect countries and populations, and their frequency and intensity are expected to grow. Over longer time horizons, physical risks are expected to have a global impact on socio-economic development and ecosystems.
Avoiding climate risk underestimation
The authors show that both portfolio losses and value at risk (VaR) are significantly underestimated when neglecting tail risk scenarios and asset-level information. This information is crucial for a more robust assessment of economic and financial risks from unmitigated climate change.
In turn, a better assessment of firms’ physical risk can support advances in academic research into adaptation, as well as the design of policies and financial instruments aimed at building resilience to climate change and filling the adaptation gap.
Gaps in knowledge…
The authors identify three knowledge gaps in assessing the financial impact of such physical risks:
- Limited access to information at the level of firms’ physical assets – their location, financial value, non-financial information (e.g., capacity, role in value chain). This means many studies use average sector values and proxy locations (e.g., central office instead of each production plant), which can lead to a mis-estimation of economic and financial shocks. Also, data on the ownership chains related to physical assets tends to be incomplete or hard to reconstruct.
- Current analyses of climate-related physical risks rely either on scenarios of chronic risk, i.e., long-term climate pattern shifts such as sea-level rise; or on acute risks, i.e., extreme weather events such as cyclones or floods. Focusing on one or the other can lead to an underestimation of the overall economic and financial impact of physical risk.
- The finance literature has analysed the impact of past climate hazards on asset prices, but it has neglected information on climate scenarios and the forward-looking nature of climate risk.
…and filling them
Addressing the gaps, the study describes an asset-level assessment of physical climate risk:
- The approach first breaks down the firm’s revenues into business lines and units to estimate the relative contribution of each physical asset. Assets are mapped to geo-localised non-financial information (climate, environmental, business) at the individual plant level, with information about the ownership chain and financial information at the level of contract and issuer. This enables the development of a model connecting financial, climate and extra-financial information.
- The exposure of each asset to acute and chronic risks is assessed.
- The study develops a valuation model that translates asset-level physical shocks and economic reactions to them into the impact on expected value, focusing on equity holdings.
In the study, the methodology is applied to international companies that own plants in Mexico, and to global investors that hold equity in such companies. Mexico was chosen in part because it is well integrated into the global value chain. It also has greatly varying exposure to physical climate risks, so some assets may suffer only moderate losses while others may be damaged catastrophically.
After computing investors’ average portfolio losses and VaR, significant underestimations of financial risk was shown to stem from neglecting asset-level data (70%) and tail risk (82%).
Insights for investment decisions
The study helps close a gap in the financial assessment of physical climate risk. It provides a transparent, science-based and replicable approach that can be tailored to different types of hazards, countries and financial contracts. It thus helps strengthen climate-adjusted financial valuation and risk assessment, with insights and implications for investment decisions and financial regulation.
In particular, this methodology allows for a more cogent understanding of investors’ exposures to climate physical risks and thus to more coherent investment and policy decisions for adaptation.
Climate-related physical risk assessment remains the poor cousin of ESG research. This study shows the considerable work that remains to be done in the area and provides interesting leads for future developments
Thibaud Clisson, Climate Change Lead at BNP Paribas Asset Management
[1] The paper was presented at the 2022 BNP Paribas Asset Management-sponsored conference of the Global Research Alliance for Sustainable Investment and Finance (GRASFI). The authors are Giacomo Bressan, Anja Duranovic, Irene Monasterolo and Stefano Battiston
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