David Carlin, Head of Climate Risk and TCFD, UNEP Finance Initiative shares his insight ahead of Climate Risk USA

The ripple effect of physical risk

David Carlin, Head of Climate Risk and TCFD, UNEP Finance Initiative

Below is an insight into what can be expected from David’s session at Climate Risk USA 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

As the world grapples with the escalating challenges of climate change, financial institutions face a pressing need to address physical risks that can significantly impact their portfolios.

From the increasing frequency of natural disasters to the long-term consequences of a changing climate, these risks have the potential to disrupt operations, strain financial stability, and tarnish reputations. In this article, we will delve into the intricacies of physical risk and its implications for institutional portfolios.

By exploring the compounding effects of these risks, effective management of internal and external physical data, the role of physical mapping in risk mitigation, and the importance of viewing physical and transition risks holistically, financial firms can not only safeguard their portfolios but also play a crucial role in tackling humanity’s greatest challenge – climate change.

What is physical risk, and how will this open up institutions’ portfolios to vulnerabilities?

Physical risk encompasses an array of threats arising from natural disasters, extreme weather events, and the manifestations of climate change. These include chronic risks, such as rising temperatures and sea levels, and acute risks such as wildfires, heatwaves, and hurricanes.  For financial institutions, portfolios spread across diverse regions and industries may experience different vulnerabilities. For example, companies heavily reliant on specific geographic areas for raw materials or production may face severe disruptions in their supply chains due to climate-related events. Climate impacts can result in increased costs, reduced revenue, operational challenges, and potential financial instability.

What is the impact of compounding physical risks? How will this affect other areas of the organization?

The compounding effects of physical risks have profound implications across various dimensions of financial institutions. Financially, institutions may experience escalated insurance premiums and reduced coverage as insurers reassess risk levels associated with physical perils.

These financial burdens can strain budgets, impact profitability, and necessitate a reevaluation of investment strategies. Moreover, supply chain disruptions caused by physical risks can lead to production delays, inventory shortages, and heightened costs. Such challenges can erode customer satisfaction, damage brand reputation, and diminish market competitiveness.

Additionally, institutions may face regulatory scrutiny and legal liabilities if they fail to effectively address physical risks, potentially harming employees, customers, or the environment.

Internally, institutions may need to allocate significant resources to infrastructure upgrades, resilient systems, and disaster preparedness measures to mitigate the impact of physical risks.

However, these investments can strain capital expenditure budgets and divert resources from critical areas such as research and development, innovation, and employee growth initiatives. Therefore, proactive risk management strategies are imperative to address the compounding effects of physical risks.

How can firms effectively manage internal and external physical data?

The effective management of physical data is crucial for financial firms to identify, assess, and mitigate physical risks. Here are key practices to consider:

  • Internal data management:
    • Establish robust data collection processes to gather comprehensive information on assets, locations, and vulnerabilities within the organization.
    • Implement comprehensive risk assessment frameworks to analyze the potential impact of physical risks on critical operations and portfolios.
    • Develop contingency plans and business continuity strategies to minimize disruption and facilitate swift recovery in the face of physical risk events.
    • Regularly update and validate internal data to ensure accuracy, relevance, and readiness for risk modeling and analysis.
    • Consider new technologies and big data techniques in order to more effectively draw insights from existing data and extrapolate for missing data.
  • External data management:
    • Leverage external sources of data, including climate models, hazard maps, and regional risk assessments, to supplement internal data and gain a broader understanding of physical risks.
    • Collaborate with industry associations such as national banking associations, NGOs such as UNEP FI and PRI, research institutions, and governmental bodies to learn about emerging trends and methodologies and improve access to quality physical risk data, insights, and best practices.
    • Engage with clients to identify data gaps and future data expectations.
    • Work with consultants or data providers to enhance expertise and analytical capabilities in assessing physical risks.

By effectively managing internal and external physical data, financial firms can enhance their understanding of physical risks, identify vulnerabilities, and implement appropriate risk mitigation measures.

How can institutions effectively use physical mapping to mitigate physical risk?

Physical mapping, also known as spatial analysis, serves as a powerful tool for financial institutions to identify, visualize, and mitigate physical risks. By overlaying geographical data with detailed information about assets, infrastructure, and vulnerability, institutions gain a comprehensive understanding of their exposure to physical risks.

Physical mapping facilitates the identification of high-risk areas, the assessment of potential impacts, and the allocation of resources for risk mitigation. Furthermore, it promotes effective communication and collaboration among stakeholders, enabling informed decision-making and the implementation of resilient measures.

Integrating physical mapping into risk management frameworks empowers financial institutions to mitigate physical risks and enhance overall resilience. An example of such integration at a bank would be the use of climate data in risk scorecards used to rate potential borrowers.

How can we view physical and transition risk in totality? What is the importance of this?

Viewing physical and transition risks holistically is paramount for comprehensive risk management within financial institutions. Physical risks pertain to direct and immediate threats posed by natural disasters and climate change, while transition risks encompass the long-term implications of transitioning to a low-carbon economy.

By considering these risks collectively, financial firms can identify potential synergies, trade-offs, and interdependencies. For instance, investments in renewable energy sources not only mitigate physical risks by reducing greenhouse gas emissions but also align with decarbonization goals, addressing transition risks.

Taking a unified approach to physical and transition risks enables financial institutions to develop robust and integrated strategies, optimize resource allocation, and contribute to the global fight against climate change.