Kayenat Kabir, PhD, Senior Climate Advisor, FinDev Canada
This blog presents the key elements of FinDev Canada’s approach to physical climate risks, why it is important to our business, and where we want to go next- hoping that it will create further dialogue and knowledge exchange.
Last year the world witnessed the warmest year on record and in Alberta, Canada, we saw over 700,000 hectares of land burning down in wildfires including in the world-famous Jasper National Park. Climate change is a defining reality of our time. And it brings a host of physical risks, from increased dramatic events like floods, hurricanes, and wildfires (acute risks) to longer-term shifts in climate patterns, such as changing temperatures and precipitation (chronic risks).
These physical climate risks have significant financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruptions. In 2022, floods in Pakistan resulted in an estimated USD 392 million in non-performing loans and USD 2.8 million in physical infrastructure damages in the banking and microfinance sectors alone.
Figure 1: Climate-related risks, opportunities, and financial impact; The Task Force for Financial Disclosure (TCFD) identified four major categories: revenues, expenditures assets and liabilities, and capital and financing, through which climate-related risks and opportunities may affect an organization’s current and future financial positions. Source: Task Force on Climate-related Financial Disclosures (TCFD), 2017, pp. 8-9.
Despite the potential financial implications of physical climate risks, a study by the World Resources Institute (WRI) and the United Nations Environment Program Finance Initiative (UNEP-FI) revealed less than half of the financial institutions surveyed for the study reported on physical risks analysis in their climate related disclosures. Of the assessed banks, less than 20% are assessing the impact of physical climate scenarios on their businesses.
The good news is that an increasing number of development finance institutions (DFIs) and their clients are assessing physical climate risks, while collaboratives like Adaptation and Resilience Collaborative (ARIC) are making efforts to harmonize the methods.
Breaking Down the Risk
For better understanding, first let’s break down physical risks which is typically evaluated based on three elements:
Hazard: What can cause harm, such as floods, hurricanes, drought, and changing temperatures.
Exposure: What is in the way of the hazard that can be harmed, such as buildings, people, and crops.
Vulnerability: How susceptible these elements are to harm, e.g. how drought resilient a crop is.
Consider a financial institution (FI) that has provided a loan to a primary agricultural company. In the event of a drought, there could be reduced yield or crop failure, which in turn would impact the company’s financial returns, making it a credit risk (the possibility that a borrower may fail to meet their financial obligations) for the FI.
To determine the physical risks of this transaction, the FI would need to assess the likelihood of drought (hazard), the extent to which the borrower’s revenue generating operations /assets such as land, machineries and crops are in the drought region (exposure), and how vulnerable the borrower’s assets and operations (e.g. crops and farming practices) are to drought conditions. Vulnerability is based on both sensitivity to the hazard (e.g. drought resistance of a crop) and the borrower’s ability to prevent, respond to, and recover from the hazard (adaptive capacity). Doing so would help the FI account for physical risks in its financial planning, and plan adequate risk mitigation measures.
Figure 2: Breaking down climate physical risk. Source: Adaptation and Resilience Investors Collaborative. (2024). Modified physical climate risk assessment and management figure. In ARIC Physical Climate Risk Playbook (p. 6) which is based on IPCC Fifth and Sixth Assessment Reports. UNEP FI.
How does FinDev Canada assess physical risks?
At FinDev Canada, climate and nature action is one of our three development impact goals and key to the execution of our mandate. In 2021, we launched our inaugural climate change strategy which recognizes the importance of climate risks in our operations. And in 2022, we developed our climate physical risks assessment approach, informed by our work with ARIC.
We apply a climate lens to all our financing and investment opportunities and treat climate risks -both physical risk and transition risk - as financial risks. Transition risk, which is associated with transitioning to a low carbon economy, is low for our portfolio. Given that we operate in regions that are highly vulnerable to climate impacts – the Indo Pacific, Latin America & the Caribbean, and Sub-Saharan Africa – identifying and managing physical risks in our operations is particularly important to us.
Assessing every transaction
We assess physical (and transition) risks during the pre-screening and due diligence phase of every new transaction. Based on hazard, exposure and vulnerability, we consider inherent risks (linked to the client’s location and business activities) and residual risks (linked to the client’s risk management capacity). Using this approach, physical risks were assessed for new direct transactions such as corporates and project finance in 2022, and for all new transactions since 2023.
Different approaches for direct and indirect investments
For direct investments, such as our investments in renewable energy plants, physical risks are assessed at asset-level using the location of a plant (an asset) or regional concentration of assets. We score current and future risks based on the likelihood of current and future hazards, exposure and sensitivity to hazards, and overall adaptive capacity.
In the case of indirect investments such as funds and financial intermediaries, we take a slightly different approach. Leveraging available data, for indirect investments we assess physical risks at country level considering the clients’ main countries and sectors of operations.
Leveraging openly available resources
We rely on openly available and easily navigable tools to assess inherent risk. For example, ThinkHazard , ND-GAIN, and Climatelinks for sub-national, country and regional-level risk profiles, and SASB for sectoral sensitivity to risks. Open databases such as Impact Lab, Aqueduct Water Risk Atlas, Climate Central Coast Risk Screening Tool, NOAA Hurricane Tracker, Global Wildfire Information System (GWIS) help assess specific hazards.
These assessed risks are systematically documented and treated as credit risks in investment decision making. We work closely with our clients to address identified gaps in managing physical risks, including through Environmental and Social Action Plans (ESAPs) and our Climate and Nature Action Technical Assistance (TA) menu. The later provides a set of interventions to support our clients in reaching their climate and nature action commitments, including ways to identify and manage climate physical risks.
Where do we go from here?
Like everyone else in the field, we are evolving our approach to assessing climate risks. One of the areas we are considering is to quantitatively assess the financial impacts of physical risks for our credit risk assessment. In current TCFD-aligned reporting, quantitative disclosures are more widely available for transition risks than physical risks, which have been typically discussed in qualitative terms.
Quantifying the financial implications of climate physical risks involves using complex forward-looking socioeconomic and climate scenarios. Predicting the long-term impacts of climate change also involves significant uncertainty which makes it difficult to quantify risk accurately and incorporate them into financial planning and reporting. Thus, it is a challenging trail to navigate, but not an impassable one.
Our increased understanding of the financial implications of physical climate risks reinforces the need for continued action. Collaboration with peer DFIs and MDBs, as well as partners within the climate ecosystem, is crucial for both the evolution of climate risk assessment methodologies and standards and the wider adoption of these practices industry wide.