Quantifying Physical Climate Risk: Call to Investors

Firefighters battle flames during the Palisades Fire. Kyle Grillot/Bloomberg via Getty

In order to support investors in developing comprehensive strategy around climate, Responsible Alpha is publishing a two-part series on financial climate risk. In part one, we review physical climate risk and provide strategies for quantifying it.

Why Model and Quantify Physical Climate Risk?

Physical climate risks fall into two categories: acute risks, such as extreme weather, drought, wildfire, and flooding (all of which are increasing in both intensity and frequency, per NASA),  and chronic risks, including rising sea levels and sustained changes in temperature or precipitation patterns (TCFD). These consequences of climate change threaten investment around the globe, with real estate, infrastructure, and commodities poised to take on the brunt. Wide ranging financial impacts include increasing cost of capital, turnover, and operations, rising insurance premiums, and decreased production capacity (TCFD). In the absence of active adaptation, S&P Global estimates yearly costs to be on average 3.3%—though up to 28%—of the value of real assets held by companies in the S&P Global 1200 by the 2050s (S&P Global).

Data from February 2023, Source: S&P Global Sustainable1

Investors are taking action as risks continue to materialize. Over 65% of respondents in USSIF surveys report using three or more climate or ESG related screening strategies across their investments. Fossil-fuel exclusions are now the most frequently reported negative screen, used by 68% of respondents, now exceeding tobacco exclusions (66%). (USSIF).

Quantifying and accounting for physical risk specifically allows investors to reduce unnecessary risk and generate portfolios with long term resilience. As individuals and corporations develop strategies for physical risk assessment, collective momentum will make action more accessible and impactful. As Bertrand Millot, Head of Sustainability at Caisse de dépôt et placement du Québec articulates in PRI panel discussion, comprehensive and collective assessment is essential. Fortification of a single asset will be minimally impactful if the community around it crumbles under climate pressure. Fortunately, comprehensive vision not only generates more dependable asset protection but also creates the potential to build broader, systemic resilience in markets. Developing a quantification strategy is the first step.

Methods of Analysis

• Historical Analysis: Analysis of historical risk data can be a powerful tool to begin informing assessment, though it provides a limited perspective, failing to account for both future plans and costs projected by firms and the unprecedented nature of the climate crisis. Still, backward-looking analysis of carbon footprint, offsets, and emissions records are a useful starting point and proxy.

• Future Analysis: Forward-looking analysis helps to counter the underestimation of climate risks inherent from using historical data and, of course, can account for future goals and costs to the firm. Examining emissions goals and scientifically supported predictions, such as implied temperature rise (ITR) of specific assets, can inform models.

• Scenario Analysis: The most prevalent risk tool by far, scenario analysis models plausible pathways (not forecasts or predictions) and measures impact on the value of various assets. Contrary to historical and future analysis, scenarios are useful in physical risk modeling given the volatile, uncertain, and unprecedented nature of climate risks. Moreover, specific financial value can be prescribed with this method, making it ideal for quantifying climate risk.

Guidance, Scenarios and Tools

Informed in assessment by historical data and future plans, firms should begin analysis by gathering information, including defining the scope of analysis; identifying hazards, exposure, vulnerability, and impact; and by identifying a framework, including climate models, scenarios, and time horizons, to work through (UNPRI). UNEP-FI offers short term scenarios on the broader environment for physical risk, based on potential action in both private and public spheres, while NOAA databases provide forecasts of various climate risks in the U.S to examine specific geographic impact. Finally, the Task Force on Climate-related Financial Disclosures (TCFD) offers a framework to help organizations disclose climate-related risks and opportunities. Their guidance emphasizes the importance of scenario analysis in understanding the financial implications of physical climate risks, and also offers an outline of financial implications of physical risks, which provides a launching point for analysis:

Source: TCFD

Case Analysis: Quantifying Wildfire Risk for California Municipal Debt (RisQ)

In 2018, the California Camp Fire—the most destructive and deadly wildfire in the state's history—swept through Butte County, leaving 153,000 acres burned and 18,800 structures destroyed. Towns impacted by the fire were left with limited rebuilding prospects and a reduced capacity to service debt, while broader financial assets, particularly California municipal bonds, saw value and ranking tumble.

In conjunction with the US Forest Service, RisQ developed a physical risk assessment tool overlaying data on building footprints, annual chance of a significant fire event, wildland urban interface, vulnerable issuers, and more. The tool not only allows municipal obligors to identify risk in specific project areas, but also to quantify potential effects on key revenue streams and economic health indicators. Moreover, employed before the 2018 wildfire, the tool effectively identified elevated risk in certain locales, including the particularly hard-hit town of Paradise, which would have been “actionable in an investment decision support context.”

RisQ’s (now owned by Intercontinental Exchange) work on wildfire risk demonstrates that physical risk can be quantified with straightforward methods, and moreover that informed and timely action has the potential to alleviate financial consequences when certain risks inevitably materialize.

RisQ’s Complete Report

Note: RisQ was purchased by Intercontinental Exchange, Inc. in 2021.

Reporting Standards

Quantified physical risk assessments not only fit well in risk portfolios but are also required by sustainability disclosure guidelines. The International Sustainability Standards Board’s (ISSB) S1 and S2 went into effect at the beginning of 2024 and require robust disclosure on physical risk. Specifically, among other requirements, firms must disclose “climate-related risks and opportunities that could reasonably be expected to affect the entity’s prospects” and current and anticipated effects of identified risks and opportunities on the entity’s business model, value chain, financial position and financial performance over the short, medium and long (ISSB).

Similarly, frameworks provided by the Carbon Disclosure Project and recently mapped onto European Sustainability Reporting Standard E1 require significant transparency in physical climate risk assessment, making well-defined scenarios, time horizon, and financial impact essential (CDP). In 2024, capital market signatories representing over US$142 trillion in assets worldwide requested CDP information from nearly 25,000 companies, reinforcing the need to disclose.

Opportunities and Action Items

Quantifying physical climate risk is no longer a theoretical exercise—it is a practical necessity for building resilient investment strategies. By integrating the strategies above and action items listed below, investors can support adaptation and drive long-term value in a rapidly changing climate.

• Adjust Investment Strategy: Use quantified risk to shift capital toward resilient assets—at both the portfolio and asset level—reducing exposure to vulnerable regions or sectors and incorporating climate scenarios into decision-making.

• Support Adaptation Measures: Engage directly with managers, companies, and projects to implement resilience strategies, from infrastructure upgrades to nature-based solutions, ensuring long-term value and stability.

• Enhance Disclosure and Transparency Meet growing regulatory expectations (ISSB, CDP) by integrating scenario analysis and physical risk metrics into reporting frameworks, improving market comparability and stakeholder trust. Responsible Alpha offers support to all companies in assessing physical climate risks for reporting guidelines to build resilience and drive returns. Explore our sustainability solutions.