Align goals Refine strategies Optimise decisions Escalate physical risk Key takeaways

Are you ready for escalating physical risk?

Decarbonisation strategies should measure and account for the two major types of risk identified by the TCFD

Transition risks These occur during the move toward a carbon-neutral economy

Physical risks These result from the impact of climate change

Transition risks These occur during the move toward a carbon-neutral economy

Physical risks These result from the impact of climate change

In many asset classes, the impact of transition risk is easier to measure than physical risk. But it is less obvious in sectors such as finance and technology and is especially problematic for alternative and private assets. Physical risk is a longer-term concern and does not affect all assets equally. Real estate and infrastructure carry greater physical risk than transition risk, for example, when compared with instruments such as bonds.

Physical risks are neglected

Many industry experts say there is not enough focus on physical risks and their potential impact, regardless of asset class.

Given present-day climate projections, Nina Reid says she has been surprised at how often transition risk outweighs physical risk in portfolio modelling assumptions.

“The physical risks that scare me are around food supply and food scarcity,” she says. “I don't think it's being captured in the models, which often focus primarily on oil and gas. To me, there are a huge number of sectors that are exposed if you get into more complex thinking about supply chains and how they operate.”

Look to the future – not at past trends

To estimate the consequences for different asset classes, Claire Jones recommends that asset owners request scenario analysis.

“If you think investment returns will be lower in the future because of climate change, and that equities will be more negatively affected than bonds, it's important you model that so you get the balance right between equities and bonds,” she says. “If you set your equity return assumption based on past trends and current market pricing, without making climate-informed assumptions, you’re underestimating future risk.”

As an asset owner, you need to ensure that your asset managers have a sound approach to factoring climate risk and opportunities into the investment process. But this is not easy.

“Even getting a good handle on physical risk for real estate assets, where the risks are very obvious and you know where all your properties are located, is hard enough,” says Jones. “But then if you take something like an investment in an equity or bond of a company that has a complex supply chain that stretches across the world, which has scope for disruption throughout, it's mindbogglingly complex. I just don't think we've got data tools in place to manage those risks yet.”

When it comes to forecasting physical risk, Nina Reid says that models need to be clearer about what they can do.

“People being open about where the models fall short is as important as the existence of the models themselves,” she says. “You could argue that recognising limitations around risk assessment should become a more explicit part of TCFD reporting. It’s a challenge when people assume that modelling gives them a complete answer.”

Phil Cliff argues that the outputs of climate scenario models are typically determined by their underlying assumptions, which are not often available, reviewed or necessarily understood. “A wider understanding of these assumptions helps qualify the results, with the aid of experienced analysts and fund managers who have followed the corporates for years, and will help improve climate understanding and decision-making.

“People being open about where the models fall short is as important as the existence of the models themselves. You could argue that recognising limitations around risk assessment should become a more explicit part of TCFD reporting. It’s a challenge when people assume that modelling gives them a complete answer.

Nina Reid

Head of Responsible Property Investment, M&G Real Estate

“People being open about where the models fall short is as important as the existence of the models themselves. You could argue that recognising limitations around risk assessment should become a more explicit part of TCFD reporting. It’s a challenge when people assume that modelling gives them a complete answer.

Nina Reid

Head of Responsible Property Investment, M&G Real Estate

Look to the future – not at past trends

To estimate the consequences for different asset classes, Claire Jones recommends that asset owners request scenario analysis.

“If you think investment returns will be lower in the future because of climate change, and that equities will be more negatively affected than bonds, it's important you model that so you get the balance right between equities and bonds,” she says. “If you set your equity return assumption based on past trends and current market pricing, without making climate-informed assumptions, you’re underestimating future risk.”

As an asset owner, you need to ensure that your asset managers have a sound approach to factoring climate risk and opportunities into the investment process. But this is not easy.

“Even getting a good handle on physical risk for real estate assets, where the risks are very obvious and you know where all your properties are located, is hard enough,” says Jones. “But then if you take something like an investment in an equity or bond of a company that has a complex supply chain that stretches across the world, which has scope for disruption throughout, it's mindbogglingly complex. I just don't think we've got data tools in place to manage those risks yet.”

When it comes to forecasting physical risk, Nina Reid says that models need to be clearer about what they can do.

“People being open about where the models fall short is as important as the existence of the models themselves,” she says. “You could argue that recognising limitations around risk assessment should become a more explicit part of TCFD reporting. It’s a challenge when people assume that modelling gives them a complete answer.”

Phil Cliff argues that the outputs of climate scenario models are typically determined by their underlying assumptions, which are not often available, reviewed or necessarily understood. “A wider understanding of these assumptions helps qualify the results, with the aid of experienced analysts and fund managers who have followed the corporates for years, and will help improve climate understanding and decision-making.

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