A practical approach to climate risk integration

Physical climate risk integration remains at an early stage for many investors. The sector has devoted significant attention to financed emissions and portfolio decarbonization, but acute and chronic physical climate risks, such as drought, heat stress and extreme weather events, and their potential impact on investments are often less well understood.

Climate risk integration starts with a clear objective

The first article in this series argued that sustainability risk integration is gaining importance because of increasing financial materiality and regulatory scrutiny. This second article focuses on practical application by introducing a simple framework that helps guide the key decisions and questions for structuring the assessment process, whether this is for an organisation that is just starting its integration journey or one that is refining its existing approach. Next, we apply the framework in practice, assessing sovereign bond drought risk as a stylized example.

It is important to remember that any result, whether a risk exposure number or expected financial impact (by year x) is the final outcome in a chain of modelling considerations, which include scenario and model decisions, damage functions and financial transmission mechanisms, each with its own assumptions and uncertainties. The objective should not be to produce a single numerical estimate, as that would disregard uncertainty and lead to false precision. Rather, it should identify potential risk exposure concentration, prioritise further investigation into specific assets or hazards, identify sensitivities and uncertainties and how to use this information in practical ways.

A practical framework to guide the process

The overall goal of climate risk integration should be to support the firm’s objective and the user group with risk information that contributes to the decision-making processes. This can be through insights to support investment teams in their due diligence and portfolio management, help risk functions in monitoring concentration risk and uncertainty, or improve the ability of the board to set overall portfolio risk appetite and strategic asset allocation.

Organisations can be at very different stages of their climate risk integration journey and internal capabilities, available resources and portfolio characteristics can differ significantly across firms. Some firms are taking first steps in climate risk assessments with limited resources, relying primarily on holdings data, sector classifications, manager information and publicly available climate scenarios. Others already have more sophisticated approaches that use geospatial data and vendor climate models to estimate financial impact.

Likewise, physical climate risks do not affect all assets equally. Materiality depends on the asset class, sector, geography and investment horizon. For listed companies, risks may be transmitted through facilities, supply chains and revenues. For infrastructure, real assets and real estate, exposure is often linked directly to location, hazard vulnerability and adaptation requirements. Sovereign and local-government debt are exposed through broader economic channels, including impacts on infrastructure, productivity, public finances and fiscal resilience. These considerations determine which insights will be most useful.

The framework provides a stepwise approach to determine the objective and user group and the subsequent steps. It can be adapted to different maturity levels and investment contexts and is inspired by the IIGCC Physical Climate Risk Assessment Methodology (PCRAM), but broadened beyond physical asset and project-level applications.

Applying the framework to sovereign bond drought risk

For many asset owners and institutional investors, fixed income represents a substantial share of the total portfolio and serves a defensive, cash-flow-generating function. Sovereign bonds especially often have an investment horizon of many years, which exposes them to both acute and chronic physical climate risks. These risks can translate into financial materiality through their impact on economic activity, productivity, public infrastructure, impacting public finances and ultimately sovereign credit resilience. Despite this, most investors have not structurally assessed sovereign bond exposure to climate risks in portfolios.

We use the following illustrative example to apply the framework described earlier in practice.

The starting point is the Define stage. The objective in this example is to do a physical risk assessment for the investment board of an institutional asset owner, specifically for their defensive sovereign bond portfolio. The objective is to understand how vulnerable its eight European sovereign bond holdings are to (severe) increases in physical climate risk over time and different scenarios. This information can guide further due diligence, asset allocation and risk appetite decisions. 

The Scope is deliberately very narrow in this example. Because the organisation has limited resources the assessment is performed as a quick scan using publicly available risk data. We focus on extreme drought risk data obtained from scientific project Climate Impact Explorer for the eight sovereign bond issuers. Exposure is assessed for 2025, 2030 and 2050 under two different climate scenarios from the Network for Greening the Financial System (NGFS): Current Policies and Delayed Transition. In the former scenario no new additional climate policy is enacted and physical risks increase significantly over the longer term; in the latter policies and green technology follow with a lag and physical risks increase moderately. 

Results of the Assess stage are shown in Table 1 and indicate that extreme drought exposure increases materially across all countries under both scenarios towards 2050. Mediterranean countries are and remain the most exposed, with Spain, Italy and France showing the highest levels of future drought risk under both scenarios. However, exposure also increases significantly in Northern European countries but from a lower starting point. By 2050, differences between climate scenarios become more pronounced, but projected exposure remains significantly above current levels in all cases.

These results remain similar when accounting for where population or economic activity is located within a country and how this intersects with where in the country drought exposure is highest. Graph 1 illustrates that regional differences within a country can also be relevant, particularly for investors in state or municipal debt. For example, increases in drought exposure between 2030 and 2050 within Germany are highly concentrated in Southwestern states.

The Assess stage also identifies priorities for further investigation. This may include assessing additional physical risks, expanding the analysis to emerging economies, and linking sovereign-level findings to sector-specific exposures in other parts of the portfolio. Future analysis could incorporate resilience factors such as infrastructure quality and governance capacity, as well as opportunities to support countries’ adaptation through green and sustainability bonds. Next iterations can then be progressively extended towards financial transmission channels, credit implications and estimates of financial materiality. They can also structurally account for the uncertainty associated with these estimates over time, and with potential non-linear effects such as climate tipping points.

In the Integrate stage, assessment findings are translated into information that supports investment and risk management decisions of the board. The assessment provides input for discussions on concentration risk and resulting limits on country allocations and maturity profiles. It can also guide stewardship priorities and green bond allocation targets. The assessment provides evidence that physical climate risks are being systematically considered, supporting dialogue with supervisors that are increasingly focused on the topic. Finally, it can support communication with pension fund beneficiaries and other stakeholders regarding the organisation's approach to climate risk management.

The Refine stage focuses on progressively strengthening the assessment and the organisation's climate risk capabilities. For example, assessing additional physical risks, expanding the scenario set, and broadening the country scope to emerging market sovereign issuers. This also includes periodically updating the assessment and ensuring climate risk information is reflected in board reporting and KPIs. Depending on available resources and objectives, the organisation can complement the initial public data sources with specific vendor datasets that provide additional insight into economic transmission channels, financial impacts and asset pricing implications. These steps should be guided by a clear roadmap that defines priorities, responsibilities and milestones, and embeds climate risk considerations within the broader governance and decision-making processes.

 Available at: https://climate-impact-explorer.climateanalytics.org/