The escalating frequency and severity of extreme weather events worldwide have brought physical climate risk to the forefront of investment concerns. This summer alone, Europe experienced unprecedented temperatures, while the UK, Japan, and South Korea marked their hottest recorded summers. Floods displacing millions in Bangladesh and Pakistan have further emphasised that physical climate risk is not a distant threat but a pressing reality demanding urgent investor attention.
Asset owners and managers increasingly prioritise understanding and assessing these risks within their portfolios. According to industry participants, this shift is driven more by regulatory pressures and advancing methodologies in climate scenario analysis rather than isolated weather incidents. For instance, Railpen, a £34 billion UK pension fund, recently elevated physical risk management as a core investment priority, reflecting recognition that all climate pathways entail some degree of potentially catastrophic physical risk.
Legal & General Asset Management echoes this approach, employing broad scenario analyses encompassing global warming trajectories from 1.5°C to upwards of 4°C to capture a wide spectrum of plausible outcomes. This contrasts with earlier, narrower views and underlines the current policy uncertainty surrounding climate projections. Real assets, particularly those directly owned and managed such as real estate, have benefited most from this deep dive, with site-specific assessments enabling tailored adaptation measures like flood defenses and storm damage mitigation.
Regulatory developments are catalysing these efforts. The UK’s climate adaptation planning mandates and the EU’s Corporate Sustainability Reporting Directive have prompted pension funds such as KLP in Norway to adopt more systematic and standardised risk assessments for their real estate holdings. KLP’s focus on low-cost, high-impact "no regrets" strategies such as improving building facades against stronger storms illustrates practical adaptation steps already underway. These measures not only enhance resilience but also aim to safeguard or increase asset valuations.
However, the challenge differs markedly across asset classes. Active investors with concentrated portfolios, like renewables and tech-focused Impax Asset Management, thoroughly integrate physical risk evaluations into their investment criteria, particularly given vulnerabilities such as data centres’ dependence on water and exposure to flooding or drought. Impax also investigates how insurers are pricing these risks, anticipating an emerging insurance gap as premiums rise with climate threats.
Conversely, broad-based investors managing extensive portfolios face significant hurdles due to a lack of comparable, actionable company-level physical risk data. Some firms are therefore developing innovative approaches like internal country-level GDP impact models to inform investment decisions. Passive investors, which dominate large swathes of markets, often find themselves unable to influence physical risk profiles directly, constrained by benchmark mandates.
While some investors seek to divest or avoid high-risk geographies, others, including KLP, focus primarily on systemic risk mitigation through emissions reduction, believing corporate adaptation will occur as companies seek to maintain operational viability and insurance access. This reflects a recognition that effective carbon pricing mechanisms necessary to drive widespread decarbonisation remain insufficient globally.
In addition to portfolio-level actions, many investors are expanding internal capabilities to manage physical climate risks more effectively. For example, Border to Coast collaborates with external experts to conduct climate scenario analyses, providing insights to asset managers to integrate climate resilience into investment processes. Aberdeen Investments is developing a "climate heat map" to identify at-risk companies and prompt targeted asset management responses, building upon existing real asset risk assessments.
Beyond individual investment firms, broader industry initiatives are emerging to support consistent climate risk integration. The United Nations Environment Programme Finance Initiative has released a detailed playbook guiding investors through assessing and managing physical climate risk within equities and debt. Meanwhile, European asset managers are adopting sophisticated risk quantification tools to meet regulatory demands like the EU’s Sustainable Finance Disclosure Regulation and to enhance portfolio resilience.
Collective action is also advancing through alliances such as the Net-Zero Asset Owner Alliance, which manages $9.5 trillion and has set ambitious emissions reduction targets across private equity and debt, promoting climate-compliant investment engagement rather than divestment. Reports from collaborations like the Sustainable Markets Initiative provide asset owners with strategic recommendations to embed climate considerations deeply into investment decision-making.
Research highlights reinforce the urgency: climate-related damages globally could cost between $1.7 trillion and $3.1 trillion annually by 2050, with sectors like real estate under intense scrutiny due to their substantial greenhouse gas emissions and exposure to physical climate hazards. Industry guides from bodies such as the Principles for Responsible Investment emphasise integrating climate science and transition scenarios into real asset investment frameworks, recognising both risks and emerging opportunities from shifting climate conditions.
In this evolving landscape, investors are navigating a complex, multi-dimensional challenge. They must balance regulatory compliance, risk management, and capital allocation within uncertain and expanding climate scenarios. The interplay of adaptation strategies, decarbonisation efforts, and emerging market mechanisms will define their ability to protect and grow portfolios in an era where physical climate risk is increasingly the predominant investment risk.
📌 Reference Map:
- [1] Responsible Investor – Paragraphs 1-12, 14-18
- [2] UNEP FI – Paragraph 13
- [3] S&P Global Market Intelligence – Paragraph 13
- [4] Reuters – Paragraph 14
- [5] Sustainable Markets Initiative – Paragraph 14
- [6] Zurich Resilience – Paragraph 14
- [7] PRI – Paragraph 14
Source: Noah Wire Services