Integrating the physical toll of climate change helps investors spot key risks—and opportunities.
Climate-focused investing traditionally emphasizes how well industries are transitioning to low-carbon economies, such as responding to climate-friendly regulations, greener technologies and shifting consumer needs. But transition risks and opportunities are just one of several lenses to assess climate change’s impact on the investment landscape. Physical risks and opportunities are another.
Knowing Physical Threats Enhances Risk Assessment
The number of companies that acknowledge climate change’s direct financial impact grew 24% in 2023, according to a CDP Worldwide survey. But transition risks continue to command more of companies’ attention than physical risks. Between 2009 and 2020, for example, average mentions of transition risks in 10-K filings grew from four to 10, while average mentions of physical risks rose from two to just four, based on a Brookings Institute analysis. We think such low reporting for physical risks suggests that businesses are only beginning to appreciate their effect on the bottom line.
The threats are very real, however. Physical risks can be chronic—as with rising global temperatures and sea levels—or acute, as in the case of an extreme heatwave or a hurricane. Any of these can levy substantial financial burdens on businesses and global economic growth alike.
The financial toll of physical risks manifests in several ways, but often through local property damage or total loss. There are also costs for stranded or delayed production capacity, plant closures, supply chain disruptions and legal liabilities from not adapting assets and communities to be more resilient.
Disasters can also hurt local households, from job losses to residential displacement, which has implications for labor supply and customer demand for products and services. As these local extremes add up, their macro implications can throttle global productivity, trade and government revenues, as well as sway inflation and interest rates.
Physical Risks Won’t Disappear, Prompting More Ways to Cope
As a global disruptor, climate change remains one of a handful of mega-forces likely to permanently change how the world lives, works and consumes—all directly affecting countries, assets and companies on many levels.
For example, population centers will likely shift within countries and across continents as crops fail or it becomes too hot to work outdoors. Agriculture-dependent regions could be the most vulnerable, not only to food scarcity but to modern slavery.
Emerging-market (EM) regions are especially vulnerable to physical risks—frequently the result of flooding or drought. Thankfully, we’re seeing governments and the private sector deploying more coping mechanisms across these regions. These include adaptation plans, multi-hazard warning systems and risk assessments, which we believe help offset some of EM’s high exposure to physical risk (Display). This suggests that even countries with high physical-risk potential could take effective steps to manage it—and improve creditworthiness.
