Physical Climate Risk Amplifies Financial Risk | CICERO

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Christa Clapp © CICERO

INSIGHT by Christa Clapp, Head of Climate Finance at CICERO and Jana Sillmann, Research Director for Climate Impacts at CICERO

Jana Sillmann © CICERO

Physical impacts of climate change are observed in all regions today and can impact companies in all sectors. However, there is a mismatch between the urgency of physical risk and relatively low level of awareness and incorporation of physical risk assessments in the financial sector.

| The changing climate inspires new respect for the power force of nature, with renewed awareness of the potential damages arising from our human activities. But this is also an opportunity for changing our behavior and for smart planning and building infrastructure in way that will be resilient to climate change for years to come. The recent push on climate risk disclosure regulation in the EU can help raise awareness, but the knowledge and tools to assess physical climate risk need continued attention and development. The EU taxonomy specifies adaptation activities, but does not offer clear solutions for a systemized approach on physical risk.

Resiliency planning can help mitigate physical damage to infrastructure. Passive cooling strategies to withstand heat stress can be used in new building constructions. Transportation lines can be raised, or alternative routes planned to avoid flooding. Drought-resistant crops can be planted in areas with water scarcity.

However, financial decision-makers face some challenges in adapting and using climate data to systematically assess physical climate risks. Climate data, from raw data to processed sector-specific indicators, are now easily accessible from public and private sources. However, for someone outside the climate science community to process the datacan be challenging. Climate scenarios typically have a century-long time horizon and there are significant uncertainties in interpreting seasonal and decadal predictions from these scenarios to understand climate impacts at a local level.

But these challenges should not be a barrier to improving awareness and making preliminary physical risk assessments. Our ClimINVEST research project aims to address some of the above mentioned challenges and helps bridge knowledge gaps between climate sciences and the financial sector. The project brings together climate scientists and investors to improve the level of knowledge and transparency in physical risk assessments.

 

| Physical impacts of climate change affect all sectors

Physical impacts are observed in all regions today and can have abrupt consequences. These impacts manifest themselves mainly by historically rare events becoming more variable, (sometimes much) more frequent and intense. Already observed today are stronger hurricanes, wet areas becoming wetter, drought in parts of all continents, and sea level rise accelerating faster than expected (see our report on climate scenarios for investors for more details).

 

All sectors can be impacted by physical risk via supply chains and indirect costs. Extreme events, such as recent hurricanes and flooding, influence companies across all sectors via electricity, production and transportation outages.

 

The industrial sector is most exposed to direct flooding risk, but all sectors are exposed to indirect damage via transportation, communication and supply chain disruptions. Our report on flood risk for investors breaks out the direct and indirect costs by sector for several extreme flooding case studies. Strikingly, more than 50% of the total flood costs were not covered by insurance in the cases we reviewed for this report.

 

| Deepening knowledge on floods, heat stress and drought

To help explain some of the science behind these hazards and how they can impact investments, we produced a series of short videos explaining different climate hazards, including heat stress, flooding, and drought. Some of the most surprising takeaways for investors include:

Floods expected to be 1-in-100 year events are not always caused by 1-in-100 year rainfalls – they can be caused by less intense rainfall in a flood-prone area. Flood thresholds and the area flooded by a 1-in-100-year event (return period) are often used for insurance and protection purposes. However, flood return periods are not directly linked with rainfall return periods. As ground conditions evolve via urbanization, the link between rainfall and floods can change, so past relationships might no longer be valid. Furthermore, 1-in-100 year flood and rainfall calculations have been based on historical data – but given the increased frequency of extreme events in the past ten years, these metrics and approaches need to be re-evaluated. Flooding damages can result from both heavy precipitation and overflow of urban sewage and water drainage systems.

 

Heatwaves impact different regions at different thresholds – a person living in Northern Europe will experience heat stress at lower temperatures than a person living in Southern Europe. Cities are generally warmer than their surrounding areas.  This is due to more concentrated concrete surfaces and low tree cover that affects the storage of heat (measured by the urban heat island (UHI) effect). The extent of this effect depends on local climate factors such as wind and cloud cover (which vary by season), and on proximity to the sea.

 

Drought and heat stress do not always occur together – drought can occur in moderate or even cool weather. Extended periods of drought can cause land to compact and become less able to absorb water, which can lead to more severe impacts of floods that occur several days or weeks later. The impacts can be exacerbated by poor land management practices and irreversible land and soil degradation.

 

| Physical climate risks as amplifier of financial risk

Financial decision makers are well familiar with the concept of risk and have their methods and tools to account for different financial risks such as currency or credit risks when making investment decisions. The impacts of climate extremes, which are intensifying under global warming, can act as amplifiers for the financial risks, and thus need to be accounted for in the financial risk assessment. Flooding in southeast Asia, for instance, can disrupt supply chains with ramifications for global companies such as in the automotive industry, and could, over time, have ramifications for credit risk.

But there are no standards so far for assessing physical climate risk. It would be useful to have more guidance developed on what indicators to use for monitoring and quantifying physical risk or how to incorporate uncertainties from future climate projections. There are many service providers that offer a way to outsource physical climate risk assessment via a scoring system, but the methodologies are not always transparent and could mask underlying data complexities. More transparent integration of climate information related to climate related hazards into existing risk management strategies by investors could improve understanding of physical climate risks and their relevance for overall financial decision-making.

 

Continued collaboration between climate scientists and investors is necessary to build further awareness, knowledge, and improve transparency on available assessment tools.

 

The materials we are developing with the ClimINVEST project are just a beginning to help guide investors as to what questions would be important to ask of companies in different sectors, and help inform their own internal risk analysis or to compare service providers for physical risk assessment. There is a growing field of service providers, including our subsidiary CICERO Shades of Green, that incorporate physical risk into their assessments of green finance and companies. But there is still some way to go on transparent and systematic approaches, and we welcome further collaborative efforts to improve our awareness and preparedness for our changing climate.

 

| brief bio 

Christa Clapp leads the climate finance work at the climate research institute CICERO, focusing on climate risk for investors. She is also Managing Partner and co-founder of CICERO Shades of Green Ltd., a subsidiary of CICERO that is a global leader in green ratings for bonds and other financial products. She has 20 years of experience in climate policy and economic analysis and is a Lead Author on finance and investment for the upcoming Intergovernmental Panel on Climate Change (IPCC) assessment report.

Dr. Jana Sillmann is Research Director at CICERO and leads the Climate Impacts group. She is an internationally recognized expert in the analysis of climate extremes and development of indicators for impact and risk assessment. She has leading roles in international programmes, such as the IPCC (Lead author AR6 Ch. 12) and the Integrated Research on Disaster Risk (IRDR), and she is co-chair of the Development Team of the Knowledge Action Network on Emergent Risks and Extreme Events (Risk KAN).

 

| about

CICERO is Norway’s foremost interdisciplinary climate research institute with a strong track record in research on climate extremes and impacts. CICERO has extensive experience on working with financial decision makers through its second opinions on green bonds and climate risk assessments for companies offered via the subsidiary CICERO Shades of Green Ltd.

The ClimINVEST project is led by CICERO, with project partners I4CE – Institute for Climate Economics, Météo-France, Carbone 4 , Wageningen Environmental Research, Climate Adaptation Services. The project is funded by the European research area for climate services (ERA4CS).