Report: financial losses from climate risk may be underestimated by 70%

Financial institutions could be underestimating investor losses from physical climate risk by as much as 70%, a research report has found.

The study was conducted by four European universities and explains that when financial institutions do not take asset-level information into account, they drastically underestimate investor losses.

Climate physical risks often rely on commercial methodologies that are not easily accessible, transparent or replicable and produce different results. Assessments are often based on scores, although these can not be used to assess damage to assets which is needed for climate risk pricing.

“The underestimation of climate physical risks leads to underinvesting in adaptation and mitigation, which in turn leads to delayed climate action, larger socio-economic losses and higher risks,” the paper states.

To address these limits, the researchers have developed a methodology which they say can be adapted to different countries in an attempt to fill the climate adaptation gap, and that it accounts for both historical data and future climate scenarios.

The researchers quantified physical risks for energy-releated or energy-intensive assets such as power plants and mines, which were picked for their exposure to various climate risks such as hurricanes. The shocks to the assets were then translated into economic and financial losses.

Using Mexico as an example, the researchers compared their asset-level approach with traditional assessments at the firm level and found that standard assessments underestimate the value of risk by 70%. When taking into account acute tail risk, such as cyclones or floods, it increases to 82%.

“By quantifying these potential underestimations, our methodology enables investors and corporations to better integrate climate physical risks in their internal risk assessment and risk management processes,” the paper says.

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