Climate-Related Infrastructure Failure Has Complex and Far-reaching Economic Impacts

Financial risk assessments “heavily underestimate” the far-reaching and cascading consequences of climate-induced extreme weather on critical infrastructure. In this article, climate risk modelling experts propose a novel risk assessment methodology for assessing the indirect effects of infrastructure failures.

According to the authors, Sahil Shah and Edward Baker, current physical risk assessments focus primarily on direct effects on asset value, with “scant consideration” for indirect impacts which are likely to be “much more disruptive” economically.

Major climate events will likely overwhelm critical infrastructure, including vital systems such as water, energy and transportation. These systems are vital to the functioning of economies and disruptions to them “can create major challenges for businesses”.

Banks are “particularly sensitive to loss created by damaged infrastructure” as cashflow impairment from business interruption, if severe, would likely force borrowers into default. Whereas asset damage alone will not necessarily result in a widespread increase in non-performing loans to the same extent.

To illustrate this point, the authors explore a case study in which a hypothetical tourist hotel on a Caribbean island is hit by a hurricane. The hotel may experience extensive business losses if a local port is damaged, with an impact on the probability of loan repayment, irrespective of whether the hotel itself sustains significant damage.

The authors have put forward a six-step risk assessment methodology:

1. select critical infrastructure types: with a focus on transport, energy, and water systems;
2. identify impact channels: assess hazard-specific effects on infrastructure. For example, cyclones can damage ports and power substations, while extreme heatwaves can melt tarmac and damage railway transmission lines;
3. model infrastructure breakpoints: develop bespoke fragility curves considering chronic degradation, materials and design to predict potential infrastructure failure under a specific climate event;.
4. calculate economic disruption: use macroeconomic models (eg input/output or dynamic stochastic general equilibrium) to estimate output drops and price rises, which can then be supplemented with network analysis to model transportation disruptions and rerouting;
5. estimate recovery time: analyse historical data from similar locations to predict infrastructure capacity recovery, which can vary from days to months;
6. incorporate impacts into portfolios: integrate disruption assessments into stress testing frameworks for credit risk evaluation, evaluating cash flow impairment under various hazard magnitudes to yield a distribution of possible business impairment outcomes.

Finally, the authors state that improved modelling of cascading impacts from damaged infrastructure offers financial institutions an opportunity to better assess and manage risk and offer preferential terms. This approach not only encourages businesses to enhance their climate resilience, but also enables differentiated loan pricing strategies to climate-resilient borrowers.

By incorporating the climate/credit risk nexus at the loan level, institutions can more accurately price climate change-related risk, creating a competitive advantage for forward-thinking investors and lenders.