Understanding the physical impacts of climate change (i.e. climate physical risks) is important for fund managers to identify and manage in advance the potential risks stemming from climate change, and for financial sector authorities to monitor climate-related risks to entities and products within their supervisory remit.
The economic impact of physical climate change could vary between 4% and 18% of global gross domestic product by 2050, according to estimates. The nature and size of the impact are highly dependent on the business sector considered. Within the financial sector, a key challenge is the management of the indirect exposure to climate physical risks through financial assets.
While investment funds’ portfolio vulnerabilities to physical risks appear limited given their ability to rebalance portfolios quickly and the short-term nature of their liabilities, some funds may still be exposed to climate physical risks. However, the assessment of portfolio exposures to the physical impacts of climate change is fraught with challenges. The accuracy of these assessments is subject to various limitations, while their interpretation requires context.
Such context is key to understanding the implications of choices made with respect to measurements, aggregation methodology and time horizon. This article from the European Securities and Markets Authority (ESMA) illustrates how two different assessment methodologies and data sources can nonetheless yield some insights on climate physical risk exposures, based on an analysis of EU investment fund portfolio holdings. As expected, funds domiciled in northern Europe tend to be more exposed to companies subject to flood risks, while those domiciled in southern Europe are relatively more exposed to the consequences of water supply-and-demand imbalances.