Here's why companies must address physical climate risks

Climate change is a major challenge for companies globally. The impacts of climate change are increasingly felt across almost all economic sectors, either directly or indirectly. Implications include asset damage, supply chain disruptions, and changes in customer demand. In recent years, companies have become more aware of climate risks and are adopting strategies to adapt to and mitigate these risks, such as building climate-resilient infrastructure and reducing carbon emissions in their operations. However, challenges remain for companies trying to thrive in a warmer world while managing the transition risks associated with shifting to a low-carbon economy.

Companies face two main types of climate risks: physical and transition. Physical risks arise from the direct impacts of climate change, while transition risks are associated with the shift to a lower-carbon economy, such as the implementation of carbon pricing policies, which can severely impact some sectors. Companies must closely examine climate-related risks to manage them effectively in their operations, decision-making, and reporting.

In this report, we explore physical climate risks, their conceptual background, the importance of assessing these risks, and key concerns for companies now and in the future. We will also address the potential implications of physical risks and outline strategies for effective management.

Physical climate risk refers to the negative impacts of a changing climate, including more frequent extreme weather events and long-term gradual shifts in climate. These risks can significantly affect companies in regions experiencing climate shocks. If these risks materialize, they can lead to direct financial losses, including property damage, business disruptions, and increased insurance claims. Indirectly, physical risks may change the demand for certain products or disrupt supply chains, reducing the supply of crucial inputs across industries.

Physical climate risks are generally divided into two categories: acute and chronic. Acute risks are event-driven, such as droughts, heat waves, floods, and wildfires, and cause immediate and substantial physical damage to assets. Chronic risks are long-term changes in climate patterns, such as increasing temperatures or prolonged droughts, and lead to issues like water scarcity and sea level rise. Chronic risks can affect agricultural productivity, water availability, and the habitability of certain regions, influencing asset valuations and investment returns over time.

With physical risks from a changing climate already present and growing, companies face greater challenges in building resilience and thriving in the long term. According to the Intergovernmental Panel on Climate Change (IPCC), additional global warming will increase the frequency and severity of acute physical risks and intensify chronic ones, particularly extreme temperature events and heavy precipitation. This calls for companies to enhance their understanding of and preparedness for adverse impacts. If left unchecked, these impacts can cause more disruptions to assets, operations, and supply chains.

Companies need knowledge of near- and long-term physical climate risks to assess and, if needed, adapt their business models. Assessing physical climate risks involves identifying, evaluating, and prioritizing risks. This assessment provides a baseline of current and future risks. Lacking this knowledge, companies cannot effectively manage risks or make well-informed strategic decisions.

Climate risks are a core focus for regulators and supervisors. Compliance with emerging global standards for climate risk reporting is becoming a priority for companies listed on regulated markets worldwide. In 2023, the International Sustainability Standards Board (ISSB) released its first two international sustainability disclosure standards: IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosures. These standards create a global baseline for sustainability-related disclosures. Companies are required to disclose information about both physical risks (including the amount and percentage of assets or business activities vulnerable to these risks) and transition risks, as well as climate-related opportunities. Within the EU, the Corporate Sustainability Reporting Directive (CSRD), effective January 2023, significantly increases the number of disclosures companies must make about “material” sustainability matters, including climate change. From 2024 onward, the new directive will progressively impact nearly 50,000 companies globally.

Physical climate risks affect nearly all economic sectors globally, but the impact varies by sector, asset, operation, supply chain, and geography. This makes some sectors more vulnerable to climate hazards than others. The main connections between risks and impacts on businesses include property damage, business disruption, and changes in demand and costs. For example, water-intensive operations are more vulnerable to water scarcity and increased water costs. Likewise, extreme heat events significantly impact outdoor labor productivity, such as in agriculture or construction, due to heat stress and human health effects. Additionally, assets with fixed locations face greater physical climate risk because they cannot be relocated away from climate hazards.

The IPCC provides a risk framework to understand and assess varying levels of physical impacts (see box 1). This involves assessing physical risks using climate data (e.g., historical weather records, climate projections) and information about companies' physical assets and the locations of their facilities, tailored to a company’s unique needs over various time horizons.

Analyzing sector vulnerability with widely used mapping frameworks can help capture direct and indirect physical impacts on companies. Since every firm depends to some degree on infrastructure, electricity, water, transportation, and other common services, all will likely face some vulnerability to climate hazards. For example, table 1 provides an overview of potential physical climate impacts on companies in the agribusiness sector, categorized into direct and indirect impacts.

We used the ISS ESG Climate Physical Risk Analysis dataset to simulate the financial impact of six climate hazards on company operations and sales. This dataset includes over 24,000 listed companies across 21 economic sectors, classified according to NACE Rev. 2 statistical classification of economic activities.

Our analysis focuses on the ISS ESG physical climate financial risk ratio (FRR), which measures the total financial impact of physical risks relative to a company’s revenue. Financial risk includes all costs and losses incurred due to climate hazards, including operational and market risks. Operational risks from acute hazards (e.g., tropical cyclones, floods, wildfires) involve repair costs for damaged assets and income loss from business interruptions. Heat stress, which increases production costs due to reduced labor productivity, affects labor costs, production, and sales. Market risks quantify the impact of chronic physical risks (e.g., the combined effects of drought and heat stress on agricultural productivity) on revenues due to nationwide impacts on gross domestic product. The ISS ESG uses climate models to simulate changes in climate hazards. By combining these with company profiles (including financial data and physical asset exposure) and impact models, they apply hazard-specific impact and damage functions to calculate various impacts. These calculations are then used to determine operational and market financial risks.

The ISS ESG categorizes a company’s financial risk level from physical climate hazards into five categories: very low (<0.01%), low (0.01%-0.1%), moderate (0.1%-1%), high (1%-10%), and very high (≥10%).

We selected 11 economic sectors and three regions[1] – Asia, Europe, and North America – and classified companies accordingly. Most companies in our sample belong to the manufacturing, financial and insurance activities, and wholesale and retail trade sectors (NACE codes). Figure 1 provides an overview of the ISS ESG dataset, illustrating the selected regions and sectors. The sector Agriculture, Forestry and Fishery is denoted as AFF. We assessed the current risk level of companies by sector using FRR and risk categories provided by ISS ESG, based on historical climatic data from 1950 to 2000.

[1] Based on the region where the issuer is legally registered, which usually indicates where they hold most of their assets or generate the majority of their revenue.

Currently, most companies across all sectors face low to moderate levels of financial risk (see figure 2). This indicates that their FRR is less than 1% of their company revenue. In other words, the potential financial losses from these risks are relatively small compared to their overall revenue. Companies can generally manage these risks through strategies like diversifying investments, developing comprehensive risk management plans, and adapting to market changes. Between 5% to 10% of companies in the utilities, real estate, food and accommodation, and AFF sectors have a high financial-risk level, with an FRR between 1% and 10% of their company revenue. Less than 1% of companies across all sectors are classified as having a very high financial risk level.

Financial risk also varies across regions. A larger percentage of Asian companies face financial risks ranging from 1% to 10% of their revenue compared to European and North American companies. This is particularly evident in the utilities and real estate sectors, where 14% and 10% of Asian companies, respectively, encounter such risks (see figure 3). The data used to simulate financial risks highlights some differences. Asia’s high concentration of physical assets, including property, plants, and equipment, and the span of its geography located in the tropics expose these companies to higher flooding risks. This leads to substantial damage costs and operational disruptions. Furthermore, climate adaptation measures in Asia are inconsistent. While there has been significant progress in some areas, there is a lack of cohesive strategy and insufficient monitoring and tracking of adaptation spending.

This observation aligns with other findings. In 2023, Asia was the region most affected by climate change. Asia’s dense population exacerbates these risks, as more people and economic activities are concentrated in vulnerable areas. A recent report by AON indicates that climate hazards in the Asia Pacific region resulted in economic losses of USD 65bn in 2023, primarily due to severe flooding and storms in China, as well as prolonged droughts and heat waves in India. Electric power companies in Asia are especially vulnerable, with coastal infrastructure at significant risk from rising sea levels and storm surges.

In North America, a greater proportion of companies facing high financial risks are in sectors such as AFF (9%), utilities (7%), and food and accommodation (6%). In contrast, European companies primarily experience high risks in the AFF sector (5%) (see figure 3). We anticipate that risks in this sector will be consistent across regions due to common vulnerabilities, such as sensitivity to temperature changes and water availability. For instance, higher temperatures may push many regions beyond optimal growing conditions, reducing yields. Livestock producers, who depend on grain for feed, are particularly vulnerable to declines in crop yields and rising feed costs unless they have substitution options. However, adaptation practices such as the use of tolerant crop varieties are available.

Currently, financial risk for most companies in Europe is lower compared to other regions. In our view, European countries generally benefit from progressive climate adaptation policies, high climate readiness, and low climate-change vulnerability scores. However, temperatures in Europe are rising twice as fast as the global average. The continent increasingly faces climate extremes that cause widespread disruptions that affect its energy and food security, water resources, and more.

We used ISS ESG data corresponding to the Representative Concentration Pathway (RCP) 8.5 to assess how financial risk is projected to change by 2050. The RCP 8.5 is a high-emissions scenario that projects a temperature rise ranging between 3.2C and 5.4C by 2100 (approximately 2C by around 2040-2050). This scenario helps us understand the most severe potential impacts if no significant mitigation efforts are made, highlighting the critical importance of acting now.

In Asia, 36% of companies are expected to see an increase in their financial risk level by 2050, compared to 2% for European and 6% for North American companies (see figure 4). This shift means these companies could face new financial risks ranging from 1% to 10% of their revenue, significantly higher than the current level of less than 1%. The Asian companies most affected are in the mining and quarrying and utilities sectors (see figure 5). For example, the mining and quarrying sector, known for its high water consumption and reliance on favorable physical conditions, could experience substantial supply chain and mining disruptions, as well as interruptions in energy for refinement. Future warming is expected to cause more frequent temperature extremes, heat waves, and water stress, especially in densely populated South Asian cities, where working conditions will worsen and daytime outdoor work will become dangerous. Additionally, most of East and Southeast Asia, characterized by extensive coastlines, is projected to face more intense rainfall and rising sea levels, leading to significant financial impact for companies in these sectors.

Less than 1% of companies in Asia, Europe, and North America will remain at very high risk. Most European companies are expected to stay in the same risk categories, with total financial risk of less than 1% of revenue by 2050. A recent report shows that European companies generally have more advanced plans for adapting to physical climate risks compared to other regions. This is partly due to stricter regulatory requirements and a higher level of awareness and preparedness among European companies. However, the report also notes that while many European companies have adaptation plans, their implementation is still lagging.

The findings in this article align with previous reports that have identified sectors most likely to suffer from physical climate risks. Sectors such as utilities, real estate, and manufacturing are classified as critical, with substantial exposure to these risks (see table 2). Some companies are already implementing strategies to manage physical risks. For example, manufacturing companies are diversifying supply chains to reduce dependency on vulnerable suppliers and regions, adopting water-saving technologies and practices, and strengthening infrastructure to withstand extreme events.

Climate hazards will pose varying levels of risk across sectors and regions. We assessed how six different climate hazards[2] will impact companies in the AFF, manufacturing, and mining and quarrying sectors in Asia, Europe, and North America under the RCP 8.5 by 2050 scenario.

Tropical cyclones, river floods, and coastal floods pose the highest financial risk across companies. Companies in all sectors are likely to face higher financial risks from these events. Flooding causes extensive infrastructure damage and significant economic losses, severely disrupting both operational and market activities. Previous reports also highlight the high exposure of sectors to flooding events (see table 2). For example, Moody’s ESG Solutions found that resource-intensive activities such as manufacturing and construction are particularly at risk. Manufacturing companies in Asia, especially in the computer and electronics sectors, have high exposure to floods, with significant impacts to the industry due to supply chain disruptions.

Projected risk exposure from chronic events such as prolonged droughts and heat stress indicates that financial risks will remain below 1%. However, prolonged droughts in Europe are expected to cause large economic damage and severely degrade the water resources essential for agriculture. Droughts, while primarily associated with agricultural impacts, also affect non-agricultural sectors, impacting water-intensive industries, energy production (e.g., hydropower and thermal power plants), and the hospitality and tourism industry.

[2] Tropical cyclones, river floods, coastal floods, wildfires, heat stress, and droughts.

The most critical consequence of physical climate risks for companies is their financial impact. These include costs and losses from repairs, supply chain disruptions, and increased operational expenses. Furthermore, complying with new global standards for climate risk reporting will prompt companies to invest in technologies and processes to manage these risks, potentially leading to higher costs and operational changes. Other financial impacts include increased insurance premiums and higher costs of debt. As shown, these financial impacts can vary by sector, region, and type of climate event. Therefore, companies must consider this variability in their climate risk assessments to make well-informed strategic decisions. This approach helps protect their assets, maintain operational continuity, and enhance sustainable performance.

To effectively manage physical risks, companies can implement several strategies. Regular risk assessments and scenario analyses will help companies understand potential impacts on operations and supply chains, allowing them to prepare accordingly and ensure resilient, future-fit businesses. Leveraging climate and meteorological data is crucial. Initiatives like the EU Copernicus program and Destination Earth are fostering the creation of a data ecosystem and the dissemination of high-quality data. However, the increasing volume of available data presents challenges in transforming it into actionable risk insights.

Other measures include diversifying supply chains to reduce dependency on single suppliers and regions and investing in resilient infrastructure to ensure continuity of operations during extreme weather events. Adopting sustainable adaptation practices and actively engaging with stakeholders, including investors, customers, and regulators, can build trust and demonstrate the firm’s commitment to managing climate risks. By implementing these strategies, companies can effectively manage these risks and enhance their resilience.