Understanding Physical Climate Risk: Definition, Assessment, and Impact
The effects of climate change become increasingly evident each year, with new temperature records being exceeded, as seen in 2023 or 2024 , and a fivefold increase in extreme weather events between 2010 and 2019 compared to 50 years ago. As these events become more frequent and their economic impacts grow, understanding physical climate risks and their impact on business operations is imperative.
This article provides a comprehensive overview of physical climate risk, starting with clear definitions and real-world examples to illustrate its significance. Learn how physical climate risk can be assessed and analyzed, and understand the difference between physical climate risks and transition risks.
Physical Climate Risk Definition
In the context of weather and climate risks, the Intergovernmental Panel on Climate Change (IPCC) provides the following general definition for risks: Risk is the potential for adverse consequences. Emphasis lies on the word potential which is introduced to highlight that uncertainty, or incomplete knowledge, is a key element of the concept of risk which is also explained in more detail later.
According to the Recommendations of the Task Force on Climate-related Financial Disclosures, physical climate risks are defined as risks arising from the impacts of climate change and can be categorized into two types: acute risks and chronic risks. Acute physical risks are event-driven and include the increased severity of extreme weather events, such as cyclones, droughts, wildfires, extreme precipitation, or floods. In contrast, chronic physical risks involve longer-term shifts in climate patterns, such as rising temperatures, which can lead to issues like sea level rise or persistent heat waves and change in precipitation patterns.
Example of acute physical climate risk
Example of chronic physical climate risk
What are the Physical Risks of Climate Change?
Physical risks of climate change can lead to financial impacts for organizations, including both direct damage to their assets and indirect consequences from disruptions in the supply chain. It is estimated that companies will face an additional cost of $24 billion annually due to supply chain risks associated with the physical risks of climate change.
Examples of potential financial impacts of physical risks of climate change listed by TCFD:
- Decreased revenue from reduced production capacity due to transport issues or supply chain disruptions.
- Higher capital expenses due to facility damage and repairs.
- Lower revenue and higher costs resulting from workforce impacts, such as health issues and safety concerns.
- Increased operating expenses, due to inadequate water supply for hydroelectric or cooling systems or increased cooling demand due to higher temperatures.
- Reduced production due to the necessary abandonment of production sites in high-risk areas due to damage.
- Increased insurance premiums and potential challenges in securing coverage for assets in high-risk areas.
Climate Physical Risk and its Implications
Physical climate risks can significantly impact various sectors in diverse ways, impacting operational efficiency, financial performance, strategic planning, and overall resilience.
- Agriculture and Food: In agriculture, physical climate risks such as extreme weather events and shifting climate patterns can disrupt crop yields and food production. For instance, prolonged droughts can severely reduce water availability, impacting irrigation and lowering crop outputs. This can lead to increased food prices and supply shortages. Additionally, changing weather patterns may introduce new pests and diseases, further challenging food security and farming practices.
- Power and Energy: The power and energy sector faces physical climate risks through increased temperatures and extreme weather events that affect infrastructure and operations. For example, higher temperatures can reduce the efficiency of power plants, especially those relying on water for cooling, such as hydroelectric and nuclear plants. Increased frequency of extreme weather events, like hurricanes or floods, can damage critical infrastructure, leading to costly repairs and operational downtime.
- Manufacturing: In manufacturing, physical climate risks can cause production delays and increased costs due to extreme weather events and shifting climate conditions. For example, flooding can damage manufacturing facilities and machinery, leading to expensive repairs and halted production. Extreme temperatures can further impact the quality of materials and products, necessitating adjustments in production processes and facilities.
- Chemical manufacturing: The chemical industry faces risks from physical climate impacts affecting raw material availability and production processes. For instance, severe weather events or changes in water availability can disrupt the supply of essential raw materials or chemicals needed for production. This can lead to increased costs and potential production delays. Extreme temperatures can affect the stability and safety of chemical products, requiring enhanced safety measures and infrastructure adaptations.
- Retail: Retailers are mainly impacted by physical climate risks through disruptions in supply chains. Extreme weather events can delay shipments and damage inventory, leading to stockouts and revenue losses.
- Logistics and Transport: The logistics and transport sector is particularly vulnerable to physical climate risks, as extreme weather events can disrupt transportation networks and supply chains. For instance, hurricanes, floods, or heavy snow can lead to road closures, delays, and increased fuel costs.
Overall, physical climate risks have far-reaching implications across different sectors, impacting operational efficiency, financial performance, and strategic planning. Adapting to these risks involves understanding their specific impacts and implementing resilient practices to mitigate potential disruptions.
Physical Climate Risk Assessment
When conducting a physical climate risk assessment, it is crucial to follow a systematic approach that aligns with reporting regulations such as the TCFD (Task Force on Climate-related Financial Disclosures) and CSRD (Corporate Sustainability Reporting Directive). These regulations not only require identifying potential climate-related risks but more and more also mandate quantifying them accurately.
The process of evaluating physical climate risk involves evaluating the potential impact of climate-related hazards on assets, operations, and overall business activities. In general, a physical climate risk assessment begins with identifying the relevant climate hazards for each location within a portfolio. These hazards might include extreme weather events such as floods, hurricanes, or heatwaves, as well as long-term climate changes like rising sea levels or shifting precipitation patterns.
Once the relevant hazards are identified, the next step in the physical climate risk assessment involves combining the exposure of a portfolio’s locations with physical hazard data. In the light of the inherent uncertainty in climate change projections, Correntics employs a range of climate models and scenarios. This approach allows us to capture a broad spectrum of possible future conditions and potential outcomes. Climate risk analytics software, such as the one we have developed at Correntics, facilitates this process by evaluating the severity and frequency of these hazards under current conditions and providing future projections using different probability levels of extreme events occurring. This enables a comprehensive mapping of potential physical risks, assessing the vulnerability of assets and infrastructure to the identified hazards.
Physical vs. Transition Risk
When comparing physical vs transition climate risk, it is essential to understand that these two types of risks represent different challenges related to climate change.
As already defined above, physical climate risks arise from the impacts of climate change, such as extreme weather events (e.g., floods) and long-term shifts in climate patterns (e.g., rising temperatures). These risks affect the physical assets, operations, and infrastructure of organizations, leading to potential damage, increased operating costs, and disruptions in supply chains.
On the other hand, transition climate risks originate from the global shift toward a lower-carbon economy. This transition involves policy, legal, technological, and market changes aimed at mitigating and adapting to climate change. The risks here are related to how quickly and effectively organizations can adapt to these changes. Depending on the pace and focus of the transition, companies may face financial risks, such as increased costs of compliance, shifts in market demand, or the need for significant investments in new technologies. Additionally, reputational risks may arise if organizations are perceived as not adequately addressing climate change.
In summary, both physical and transition risks require careful assessment and management, but they affect organizations in fundamentally different ways.
Examples of Physical Climate Change Risk
According to recent data from the World Meteorological Organization (WMO), extreme weather, climate, and water-related events have resulted in economic losses totaling $3.6 trillion between 1970 and 2021. Very importantly, over these 50 years, the number of such extreme events increased by a factor of five from the first to the last decade.
The forest fires of 2017 in Portugal serve as another devastating example of how the physical risks of climate change can significantly impact businesses. These fires burned hundreds of thousands of hectares of forests, shrubland, and agricultural land, causing extensive losses to both private and public property, including buildings, industrial infrastructure, energy networks, roads, telecommunications, and forestry and agricultural resources. The Portuguese government estimated that the total damage caused by the fires between June and October 2017 amounted to approximately EUR 1.5 billion.
Related to chronic physical risks of climate change, 2023 was globally the warmest year on record, at 0.60°C warmer than the 1991–2020 average, and 2024 is on the way to beat that record, according to Copernicus. Throughout 2023, heatwaves were prevalent, frequently setting new national or local temperature records. Many areas worldwide experienced extended periods of low rainfall, especially in North America (Mexico) and South America, as well as western Africa. The combination of hot and dry weather in some regions also caused widespread wildfires, particularly in southern Europe, Canada, South America, Australia, and Hawaii. The year 2023 was also notable for Antarctic sea ice, which hit record-low levels for eight months, with both daily and monthly extents reaching unprecedented lows in February 2023.
In addition to the ongoing and gradual changes, several acute events in 2023 had a significant impact, underscoring the increasing physical risks posed by climate change. These key events led to considerable economic losses and highlighted the pressing need for adaptation and mitigation strategies. Some of the most impactful events in 2023 in terms of economic loss were:
- China Tropical Storm Doksuri: Tropical Storm Doksuri brought severe flooding and destruction to China, leading to economic losses of around $25 billion due to damaged infrastructure, homes, and agricultural land.
- USA Drought: A prolonged drought in the United States caused significant agricultural losses, with economic impacts totalling approximately $14.5 billion, affecting food production and water resources.
- Mexico Tropical Storm Otis: Tropical Storm Otis struck Mexico, causing around $12 billion in economic losses, primarily due to damage to homes, businesses, and infrastructure.
- Italy Flood: Severe precipitation and associated flooding in Italy resulted in an estimated $9.8 billion in economic losses, disrupting communities and causing widespread damage to property and infrastructure.
Physical Climate Risk Assessment with Correntics
Correntics provides a holistic physical climate risk assessment tool that allows companies to evaluate and manage the impacts of climate change on their operations. Our platform integrates advanced climate risk analytics, assessments of exposure to environmental hazards, and scenario analyses to support strategies for climate resilience.
With scientifically robust data and high-quality risk quantification capabilities, the Correntics software enables businesses to conduct thorough physical climate risk assessments. This process involves identifying relevant climate hazards, such as floods, hurricanes, heatwaves, or long-term changes like rising sea levels, and combining this information with the exposure of specific locations within a company’s portfolio. Our platform aligns with key reporting frameworks, including the TCFD (Task Force on Climate-related Financial Disclosures) and CSRD (Corporate Sustainability Reporting Directive), ensuring that the assessment not only identifies potential climate-related risks but also quantifies them accurately for an informed decision-making process.
