As the climate is changing, extreme events are becoming more frequent and more severe. Their importance varies across geographies and time horizons, between different industry sectors and individual borrowers.
Therefore, it is becoming crucial to define a sound approach that allows financial institutions to assess how fixed assets can be impacted by those events and to which extent this impact could further lead to changes in output and asset values, and disrupt supply chains.
Physical risks can be broken down in three key parameters to differentiate how assets are exposed to this new category of risk:
- Frequency: event-based/chronic
- Severity: the potential impact of a hazard (dependent upon the hazard type)
- Geographic coverage: the zone or area that is affected by the hazard
The Task Force on Climate-related Financial Disclosures (TCFD) distinguishes two types of physical climate risks: acute and chronic. Acute physical risks arise from changes in event-driven hazards, such as an increased severity of cyclones, hurricanes or floods. Chronic physical risks refer to longer-term, incremental shifts in climate patterns that may cause sea level rise or chronic heat waves.
The potential impact stemming from both acute and chronic events depends on the input scenarios chosen by the institution to make forward-looking and probabilistic assessments, according to a specific return period (i.e. the time horizon required so that climate change risk factors can fully materialize).
A common practice is to leverage on the scenarios prepared by The Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Scenarios were first published in June 2020 and updated a year later. There are three main advantages of those scenarios:
- Scenarios were specifically designed to address the needs of prudential authorities and central banks to assess the resilience of the financial sector.
- Scenarios allow for some degree of comparability across jurisdictions because are publicly available and can be employed by multiple authorities.
- Entities can avoid having to duplicate expertise and financial resources to develop their own scenarios.
As above outlined, institutions are required to use a proportionality and materiality approach when defining their physical risk assessment and need to identify the best balance in terms of spatial coverage and resolution of the datasets, which will largely depend on the type of climate event under analysis.