4. The rise of climate physical risk

When we're thinking about climate risks, inherently they are long term. Right? And so when you extend your view out, not just to the next year, but the next five, 10, 20 years, inherently with that comes uncertainty. I think the challenge that an investor sees that then they do have a physical risk assessment one year for their portfolio. And then if they repeated the following year, they, with a different provider, they seem very substantial changes. And I think the reason is not that one provider might be better than the other. It could be, but it's also that, you know, that challenger around finding those datasets and really making sense of that. How do you really effectively manage those total portfolio costs? Individuals are able to build their personal pension pots for retirement. You share the same passion that I do for the story, the theory, and the data coming together. (soft music) Hello and welcome back to investing for tomorrow. The podcast where we explore how long-term investors can stay grounded in a fast-changing world. I am your host, Louisa Mintekemp. When we think about climate risk, it's often the long-term transition story that dominates the headlines, policy, net zero targets, decarbonisation. What we're here to talk about today is physical climate risk. The floods, heat, storms, and shifting conditions that are already starting to impact assets, operations, and portfolios today. And with climate phenomenon like the current El Nino disrupting and impacting countries around the world, it raises an important question. Our investors are quits to understand and act on these risks. Today we're going to unpack what physical climate risk actually means in practice. How it's starting to shop in investment decision-making and what investors need to think about. I'm joined by Muhammad Anwar and Alvaro Linaras from WTW's Climate Practice Team. Thank you both for joining us. So to kick off Alvaro, I start with you. What is physical climate risk and how have you seen this evolve over the past couple of years? - Yeah, so in simple terms, it's the impact of the environment to your own assets, people or businesses. So things like flood, heat wave, things that we are all familiar with, especially this week in the UK. So the sort of impacts that physical risk bring to your assets, it could be direct. So things like property damage to the asset or business interruption. But it could also be indirect. So there are very complex things such as how does the impacts in the supply chain could affect my business? Or more broadly, if you are thinking, for example, about a business that relies on raw materials, it could be things like impact to those sourcing regions or impact in agricultural commodities that could have a very material impact to those businesses as well. So it's both the direct and the indirect impact of physical climate risk. In terms of how it has been evolving in the past years, well, I think it's more on, I think how it incorporates and how investors have been thinking about it. It's, we are starting to see a big shifts on it. So to give you an example, in terms of corporate clients, it tend to be a topic that landed always in the sustainability team and it still does. But there was in a connection done with risk. And we see that basically the risk manager, the insurance buyer, it has to be also driving and also aligned with that conversation. So really like having, and we are seeing that shift in recent years, sustainability teams working together with risk managers, which we think that it's really forward thinking and really makes an impact on how the company can then make good decisions on adaptation, investment, insurance, and so on. Yeah, and I think in terms of the insurance market, for example, I think a lot of underwriters are taking climate risk very seriously. The challenge with insurance is that insurance is just priced here two years. So sometimes it's difficult to really think about climate change in that framework. But we really see how insurers and the writers, they are really starting to think and to embed into their analytics. What could those shifts be in the, not just the next year, but the next few years? And that is really driving a lot of conversations in surability, investment terms, and so on. And you touched on risk there. And we talk a lot at thinking ahead about systems level investing, thinking about the whole approach to how we actually invest. And I wondered if you could talk maybe Muhammad a bit more about how you actually assess risk from that perspective. Yeah, no, I think it's a really good question. I mean, Alburo there talked a little bit about kind of the time horizons for this, right? And how the insurance market works to certain time horizons and pricing it. But when we're thinking about climate risks, inherently they are long term, right? And so when you extend your view out, not just to the next year, but the next five, 10, 20 years, inherently with that comes uncertainty, right? And we capture some of that uncertainty with climate scenarios, right? So the first step is ready to understand what those plausible futures could be, what those potential climate scenarios are. The degree of warming they related to, whether it's, you mentioned at the beginning of this, net zero would be like a 1.5 degree warming, but then a really potentially catastrophic physical risk outcome would be something like a 4 degree warming outcome. So each of these warming outcomes have a climate scenario or a transition path that they attach to them. So first point is to understand that, in a high warming future, you will have no physical risk, less transition risk, obviously, because there is essentially no transition. But in a lower warming future, you have a mix of both, right? And it's really about understanding those sources that is really important for that analytical process. In terms of the approach, right? So once you've understood the scenarios, the way we've done this a lot and has resonated really well, is not be to kind of reinvent the whole process. It's not being to say, let's invent a new metric and a new way of doing it. It's actually to try and build this understanding of the future into existing corporate finance techniques, evaluation techniques that investors are familiar with. So what that means is, when you take these scenarios, what does this mean for the fundamentals of a valuation model that an investor might be looking at? So how could the demand for a good or a product that a company is selling? How could that change? How could the cost when it comes to physical risk to do with remediation or rebuilding an asset that's been damaged? How could that be affected in these different scenarios that would have cost an insurance, be affected and use different scenarios? It's about modeling down to that level of granularity. And I think on the physical risk side, what's really important there is location, right? Your location is really material for understanding the risk exposure and the models that Albert and team have can dig into a lot of details to understand where specifically your assets are and then how they are exposed to these long-term future scenarios. So that's kind of the bottom up, right? Once you've got that understanding of what the risk is, you translate it back into those valuation models to revenue, cost, impacts and ultimately valuation, then the question is, what does that mean for you as an investor, for your portfolio? So when you group all of your different holdings together, where is that risk? Where is it concentrated? So you will find certain regions, certain sectors make you very asset-intensive sectors that have a lot of physical risk concentration, right? That can give you some ideas on how you might want to evolve your portfolio over time, right? But I think before doing that, the next consideration is timing of risk, right? When is this risk potential going to materialize? When is it going to crystallize in your portfolio? And then together, obviously simplifying a lot here with that view of where the risk is concentrating your portfolio and at what point it will crystallize, that information is what can really help you understand the risk properly and then start to think about how to deal with it. That makes sense. And in terms of the system level thinking, right? Essentially what you've done is taken a system level transformation, but made it relevant for your portfolio. You are starting from that macro level. If you think back to the scenario level thinking, and then you're making it right for your portfolio, And you also not do like in a lot of cases what you're not doing is saying, this is a company I hold. Here are its decarbonization plans or here are its adaptation plans and I'm valuing the benefit of those that's not what you're doing. They're saying, what is what is this broader systemic change? What does this systemic change mean for your asset before you basically before you've done anything about it? Right? So essentially what is the risk that you do not control then you can start to understand what other steps to take to manage that risk. So it is actually understanding the system first before the kind of the specifics of your investment. Absolutely and I've ever wondered if there's any thing you want to add there on the mindset shifts that clients need to adapt to. I think on the systemic point, I think it's really important for clients to understand that they that their business is basically part of that of that system. And we work with food and beverage companies with mining companies, extraction companies and so on and the key things there are to think about not just their own business, but the community around those businesses. And they do a lot of work and a lot of you know they spend a lot of their time on making sure that they are building a resilient community, both in terms of you know with standing more extreme events, but also. But also more chronic changes like you know like water stress and things like that because some of them operate in environments that are really really rough. And they really need to invest in the in the community right so I think yeah I think that's something we're seeing. Yeah and so thinking about what some of these you've already mentioned some of those challenges there. Mohammed do you have any more that you can help bring this to life a bit more and then have our some of some other examples that you could share to help paint that bigger picture. I mean I think that's the first the first key challenge is something we've already sort of touched on, which is how do you translate these systemic impacts into a number that you can understand and into a view into maybe investment framework due diligence framework that is familiar to you. So that's the first thing to kind of really crack and I think that's what a lot of especially as it was our struggling with is we've gone through the whole bubble of kind of the extreme metrics and all that that hasn't really fully translated into the kinds of decision making that we wanted right. They're still they're still a gap there they're still a gap to understand how do these different systemic changes actually impact things like that's at values right and and so it's that kind of first translation step and this is this kind of mirrors the experience we've had with a lot of us. And also with corporates it's that until you bridge that gap until you can translate these time it impacts into financial impacts you're never really going to get that level of traction that you need with some of these senior decision makers to then turn this into a strategic conversation right to then turn this into a conversation of what do I do about this right rather than just you know I've disclosed your exercise or a regular to exercise. So I think that that's kind of the first challenge, but we do have a few really neat examples of that, but I think on the physical side is the lot of challenges that maybe I think Alvaro you can probably get into in a bit more detail. Yeah, I think the I mean the key thing on physical risk and I think you know the whole industry is struggling with this is the granularity of of the data that you need to do appropriate analysis and it's not it's not just about finding the you know the location of of the real assets of of a of a business right is also understanding. The value of those assets to the business and also how are they linked to the to the financials of the business. So so yeah finding that information is it tends to be quite challenging unless you are working directly with that corporate and even so sometimes it's very challenging. And we go through some examples now, but yeah, I think the challenge that the investors see is that then they do have a physical risk assessment one year for the portfolio and then if they repeated the following year. They with a different provider they seem very substantial changes and I think the reason is is not you know that one provider might be better than the other could be but it's also that you know that challenge around finding those those data sets and and really making sense of them so. So yeah we I think that's the biggest challenge instead of the methodology and the approach and I think that's also evolving so I think in the you know years ago that was there were big gaps on that but now recently because of you know set things like new technologies like satellite satellite companies or or AI we are we are reducing that that gap. And yeah I mean in terms of you know to give some examples and I'm going to start maybe with a with a corporate client that that that we work with. It's it really took years of working with them to really find like refined what could be their supply chain in terms of you know working with the procurement teams trying to find out not just the first level but maybe the second third level of that supply chain map it out. And then really assessing the impacts to that supply chain to the business. It's been it's been quite challenging and and really you really realizing this sort of projects how deep you can go and how the results really change that that narrative right those like Muhammad was saying is important to to to to come up with metrics and do that quantification in in a way that is that is useful to the to the business. But yeah I mean a couple more examples maybe of of doing that with with investors I think we you know we see that there are different different different use cases. One of the things we're starting to see is investors want to have a view of climate risk so not just physical or transition is kind of combined within a the same framework. We are able to provide that portfolio level analysis and align the the transition risk metrics with the financial risk metrics. And that then helps the investor to then say OK I can use this to engage with my key you know with the critical investees and they can then then like drive drive change drive drive action right. And maybe I'll just finish with with another example of of working with with large pension funds where I think the approach and I think we were touching on this before the approach of doing this sort of analysis we we stop we start high level so more on the on the top down. And then a portfolio level scan but then then to make the analysis useful right we need to go much more granular so then once we have added identify those high risk you know concentration areas then we really dive deeper right and then we find out much more information about those investments even if they are you know equity like company level investments or if they are infrastructure investments. And then from there we really bring our our risk engineering expertise and and try to really assess what could be those those material impacts to the to the infrastructure or to specific assets right so I think that requires much more work. And it has to be done at a much smaller subset and that's why I think you know just touching on what Mohammed was saying that's why a lot of investors could are facing this challenge right is if they do a very high level settlement to their portfolio. Like how decision useful is that going to be right and if you really want to get into those decision useful metrics then you need to go much much deeper at least that's what we've what we are what we are finding. It feels like we're reaching this really critical point and an undeniable moment where we need to be focusing on this so wondered Mohammed what why is this so important now. I mean honestly so we've not run out of time I'd say but we're definitely running out of time to really properly manage these risks in a way this orderly. You know it doesn't call course kind of major system level impacts and so that that's the base that's the answer that's probably the answer at the core of all of this but on a more practical level we have seen the regulatory landscape change a lot as well. So you know we work a lot with corporates as well as as an investors and a lot of the demand driving the work is actually coming from mandatory climate reporting regulations that are kind of proliferating around the world. and now increasingly that you know, sort of mandate. financial quantification of both physical and transition risk across some of the scenarios we spoke about. So they have to do it. A lot of companies just have to do this work. But I think in parallel to that companies themselves, and we've seen this as well in terms of the demand we've had, they are engaging with us, even in cases where it's not mandatory because climate is becoming a financial risk, right? And it always has been, but it's just becoming more and more obvious whether it's to do with kind of a few physical risk impacts that have started to really affect the balance sheet and affect kind of business operations or transition risk impacts that have flown through the value chain often, you know, alongside geopolitical events which might take the headline, but can still materially affect the kind of the value of the business. And we've seen those more and more basically, right? So the CFO, the kind of chief risk officers, the CEOs are increasingly aware of these sorts of risks and want to understand how to manage them. So I think that's kind of the impractice of what's driving, what's driving a lot of the impacts. And I think what's remaining, so we talked a little bit about the gap in terms of sort of being able to quantify, right? These risks and we talked a little bit about how we've gone about that. Even achieving that, there is still a question that remains, which is what do you do about this essentially, right? How do we manage this risk? And I think there is a gap there on decision making that hasn't been solved, right? Because we have different tools, we have different leaders, we've got the insurance market that can help manage some of this for a lot of companies. We've got a company's own corporate strategy that can help diversify business and make it more resilient. You know, shift is portfolio to more resilient regions and things. We have adaptation type engagements with, you know, really sophisticated engineering that can build resilience at the asset level to physical risk impact. So there are all these different levers and strategic options, but there's no real way of optimizing these options, right? A, you know, every company has a fixed, well, relatively fixed capital budget every single year. Thing to decide how to use that, they decide how to allocate that. Where should they put their money first when it comes to climate risk management, right? Is it on the adaptation side? Is it on looking at innovative insurance options? Is it about, you know, developing a corporate strategy? So I think there are other options out there. There's even options that can be borrowed from the investment space around things like real option theory that can really help, you know, make this a problem that can be optimized, of course, with all sorts of assumptions, that takes account of all these different futures or these different scenarios, the timing of risk to say, here's what you do today, here's what you can do in five years time, and here's what to look out for in case you're in this scenario to do this, right? It's developing an option set alongside triggers that can help make decision making easier. So yeah, that thing that that in nutshell is what I'm saying is driving on it, please. Brilliant. Abar, was there anything that you wanted to add and highlight there? Yeah, I mean, I think in terms of takeaways, I think for what we are finding really critical for investors is that they need to have a process in place that doesn't only rely on a specific number, right? Because we were talking about the challenges on on quantification, on on data gaps, on basically having having the same analysis done by two different providers and being completely different. So they are they are rightly concerned and they raise this with us. So I think in terms of the framework that they need to make decisions, that's what where they should focus on. And I think that should of course have some component on on this quantification metrics, but it should be much broader. And I think it should it should it should have things like like understanding what the you know, they are investing in a company, for example. So understanding what the company has previously been exposed to in terms of historical events, historical losses. What is the governance within the company? So once there was an event or how what did they do? How do they respond or what internally how how is that governance process in terms in terms of assessing and planning for climate risk? And also looking at what are they saying, right? What is there? There what have they publicly disclosed? But also in terms of their their annual report, but also we are seeing lots of companies also disclosing what is their adaptation plan, right? What does what is their investment commitments in the future? And I think all of these information and insights kind of helps paint a bigger you know, a more complete picture than just like a number of you know, your your value at risk is X, right? So I think this this can really help investors do this due diligence also engage with those with those investees. Well you both providers are really clear call to actions there for listeners. So thank you so much. I think the final message is that really physical risk it just can't be ignored. It has to be built in to your risk models and frameworks. So I want to thank you both for explaining running through everything and really appreciate your time. Thank you. Thank you so much.