Physical Risk

Introduction

Physical risks are risks associated with the physical impacts of a changing climate, including the risk of destruction of assets and/or disruption of operations, trade routes, supply trains, and markets. These risks can be event driven (acute) or associated with longer-term shifts in climate patterns (chronic), as described in Table 3.

Physical Risk Categories
Acute	Acute physical risks refer to those that are event-driven, including increased severity of extreme weather events, such as cyclones, hurricanes, heat or cold waves, or floods.
Chronic	Chronic physical risks refer to longer-term shifts in climate patterns (e.g., sustained higher temperatures, sea level rise, changing precipitation patterns) that may cause sea level rise or chronic heat waves.

Source: This table's content is reproduced from Recommendations of the Task Force on Climate-related Financial Disclosures

Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations' financial performance may also be affected by changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting organizations' premises, operations, supply chain, transport needs, and employee safety. Table 4 presents examples of climate-related physical risks and financial impacts.

Climate-related Physical Risks

Potential Financial Impacts

Acute Increased severity of extreme weather events such as cyclones and floods Chronic Changes in precipitation patterns and extreme variability in weather patterns Rising mean temperatures Rising sea levels

Reduced revenue from decreased production capacity (e.g., transport difficulties, supply chain interruptions) Reduced revenue and higher costs from negative impacts on workforce (e.g., health, safety, absenteeism) Write-offs and early retirement of existing assets (e.g., damage to property and assets in "high-risk" locations) Increased operating costs (e.g., inadequate water supply for hydroelectric plants or to cool nuclear and fossil fuel plants) Increased capital costs (e.g., damage to facilities) Reduced revenues from lower sales/output Increased insurance premiums and potential for reduced availability of insurance on assets in "high-risk" locations

Source: This table's content is reproduced from Recommendations of the Task Force on Climate-related Financial Disclosures

Assessment Methodology

Climate change impacts financial systems both directly and indirectly (Figure 1). Direct damages refer to immediate to short-term physical destruction, including destruction of housing, critical infrastructure, and means of production which results in direct financial loss. Indirectly, climate hazards affect the financial sector via impacting the macroeconomic environment (see Transmission channels).

Acute Risk

Direct damages, primarily at the asset level, are typically assessed using a traditional risk assessment framework where risk is defined as the product of hazard, exposure, and vulnerability (ref. IPCC report). This is often done through a catastrophe modeling approach which integrates climate hazard information with exposure and vulnerability metrics to estimate the financial cost of physical damage (or “losses”) to a geographically specific portfolio of physical assets.

A catastrophe model typically includes three main components: a hazard module, which assesses the extent and intensity of climate hazards; a vulnerability module, which relates hazard to physical damage; and a financial module that translates physical damage to financial losses. The key output of a catastrophe model is the distribution of possible losses, expressed in financial terms, to the portfolio. Scenario analysis, often implemented using Monte Carlo simulations as seen in models like CLIMADA, is also usually embedded in catastrophe models where the events are modeled thousands of times with slight modifications each time to reflect the overall likely distribution of losses due to inherent uncertainty in those estimates. See the data section for lists of open-source catastrophe models.

The indirect impacts are estimated by macroeconomic models which capture how the direct damages propagate and interact with other sectoral and macroeconomic variables over time. These models require key macroeconomic indicators, such as GDP, employment, household consumption, trade flows, and country-specific socioeconomic data, to assess broader economic consequences. Examples of commonly used models are provided in the Tools and Models section.