Physical Climate Risk Models
Executive Summary
Key Takeaways
- ✓ A physical climate risk model translates hazard exposure, acute or chronic, into a financial loss figure at asset or portfolio level, requiring asset-level hazard exposure mapping as its necessary foundation.
- ✓ Acute risk loss estimation typically uses an event-probability-and-severity approach, similar in structure to catastrophe modelling, estimating expected annual loss from event frequency and damage severity distributions.
- ✓ Chronic risk loss estimation typically uses a trend-based approach, projecting gradual value or productivity impact over a multi-decade horizon against a defined climate pathway.
- ✓ Hazard data should be applied at the specific asset location and characteristics level, not a regional or sector-average assumption, since physical vulnerability varies materially even among similarly located assets depending on specific construction, elevation, or operational characteristics.
- ✓ A physical risk model's output should be expressed in financial terms comparable to the rest of the entity's risk framework, expected annual loss or value-at-risk, rather than left as a qualitative hazard score disconnected from financial decision-making.
Objective¶
This guide covers building a physical climate risk model within Climate Finance & Climate Financial Modelling, the modelling methodology behind the Physical Climate Risk term.
Asset-Level Hazard Exposure Mapping¶
A physical climate risk model requires asset-level hazard exposure mapping as its necessary foundation, identifying which specific assets are exposed to which physical hazard channel. A portfolio-level or regional-average hazard assumption cannot substitute for asset-specific exposure data when the goal is a credible financial loss estimate.
Acute Risk Loss Estimation¶
Acute risk loss estimation typically uses an event-probability-and-severity approach, similar in structure to catastrophe modelling, estimating expected annual loss from event frequency and damage severity distributions specific to the hazard type and asset characteristics.
Chronic Risk Loss Estimation¶
Chronic risk loss estimation typically uses a trend-based approach, projecting gradual value or productivity impact over a multi-decade horizon against a defined climate pathway, structurally distinct from the event-based methodology used for acute risk, and requiring its own connection to the Climate Scenario Analysis pathway assumptions underlying the projection.
Asset-Specific Application¶
Hazard data should be applied at the specific asset location and characteristics level, not a regional or sector-average assumption, since physical vulnerability varies materially even among similarly located assets depending on specific construction, elevation, or operational characteristics.
Expressing Output in Financial Terms¶
A physical risk model's output should be expressed in financial terms comparable to the rest of the entity's risk framework, expected annual loss or value-at-risk, rather than left as a qualitative hazard score disconnected from financial decision-making. A score alone cannot be integrated into capital allocation or portfolio risk aggregation in the way a comparable financial figure can.
Common Construction Pitfalls¶
Regional or sector-average hazard assumption applied instead of asset-specific mapping. Obscures material variation in physical vulnerability among similarly located assets.
Acute and chronic risk estimated using the same methodology. Fails to reflect the structurally different event-based versus trend-based mechanics each risk type requires.
Output left as a qualitative hazard score. Cannot be integrated into capital allocation or portfolio-level risk aggregation.
Recommended Practices¶
- Perform asset-level hazard exposure mapping before any loss estimation.
- Apply event-probability-and-severity methodology to acute risk and trend-based methodology to chronic risk, distinctly.
- Apply hazard data at the specific asset location and characteristics level.
- Express output as expected annual loss or value-at-risk, comparable to the entity's broader risk framework.
Continue Reading¶
Related Pillars¶
Related Technical Guides¶
Related Glossary¶
How OXXON tests thisRun a free structural check with FMAE
Frequently Asked Questions
What is the necessary foundation for a physical climate risk model?
Asset-level hazard exposure mapping, identifying which specific assets are exposed to which physical hazard channel, since a portfolio-level or regional-average hazard assumption cannot substitute for asset-specific exposure data when the goal is a credible financial loss estimate.
How does acute risk loss estimation methodology work?
Typically through an event-probability-and-severity approach, similar in structure to catastrophe modelling, estimating expected annual loss from event frequency and damage severity distributions specific to the hazard type and asset characteristics.
How does chronic risk loss estimation methodology differ from acute risk estimation?
Chronic risk loss estimation typically uses a trend-based approach, projecting gradual value or productivity impact over a multi-decade horizon against a defined climate pathway, rather than the event-probability-and-severity approach used for acute, sudden-onset hazards.
Why should hazard data be applied at asset level rather than regional or sector average?
Because physical vulnerability varies materially even among similarly located assets depending on specific construction, elevation, or operational characteristics, and a regional or sector-average assumption obscures this asset-specific variation, producing a less accurate and less actionable loss estimate.
In what form should a physical risk model's output be expressed?
In financial terms comparable to the rest of the entity's risk framework, expected annual loss or value-at-risk, rather than left as a qualitative hazard score disconnected from financial decision-making, since a score alone cannot be integrated into capital allocation or portfolio risk aggregation.
References
Related Articles
Climate Finance & Climate Financial Modelling
Climate finance is the mobilisation and allocation of capital toward mitigation, adaptation, and transition activity, and climate financial modelling is the discipline of representing that activity's cash flows, risk, and concessionality in a financial model. This page is the hub for the Knowledge Centre's climate finance content: how sustainable, green, and transition finance are distinct but related capital allocation frames, how a climate investment model differs from a standard project or corporate model in its treatment of concessional capital and additionality, how physical and transition climate risk are quantified at portfolio and entity level, and how carbon markets, climate-sector investment, and institutional governance practice build on these foundations as this domain expands.
Physical Climate Risk
Physical climate risk is the direct financial risk that climate hazards, whether sudden events or gradual change, pose to physical assets, operations, or supply chains. It is conventionally split into acute physical risk, event-driven disruption such as a flood or storm, and chronic physical risk, gradual change such as rising average temperature or sea level, since the two carry different timing, probability, and mitigation characteristics.
Climate Risk Financial Models
Climate risk financial modelling quantifies physical and transition climate risk at entity or portfolio level using a defined scenario framework, distinct from adjusting a single valuation's discount rate or cash flows. This guide covers exposure mapping, scenario-based loss estimation, and how a portfolio-level climate risk model differs in scope and purpose from the single-valuation climate risk adjustment already covered elsewhere in this Knowledge Centre.
Climate Scenario Analysis
Climate scenario analysis is the practice of constructing multiple, internally consistent narrative and quantitative pathways, an orderly transition, a delayed transition, or continued high emissions, among others, against which a financial model's climate exposure is tested. This guide covers how scenarios are constructed from macro variables and narrative assumptions, how transition and physical scenarios should be paired rather than modelled in isolation, and how constructed scenarios feed into portfolio-level climate risk quantification.