The ClimateWise physical and transition risk frameworks

The ClimateWise Insurance Advisory Council recently published two frameworks that provide practical open-source tools to address the primary risks posed by climate change to the financial sector: physical and transition risk. These frameworks enable finance sector firms respond to the expectations of the Bank of England (BoE) and recommendations of the Financial Stability Board Taskforce for Climate-related Financial Disclosure. 

In its supervisory Statement SS3/19, the PRA reports that few firms are currently addressing physical and transition risk strategically. The PRA now expects firms to embed climate change issues into governance; integrate climate risk into existing financial risk management practices; use scenario analysis to inform both of these and disclose their risks and their approach to mitigation. 

The ClimateWise physical risk framework

The physical risks of climate change derive from both specific events like storms and floods, and more gradual changes such as temperature rise, changes in sea levels and drought. The material impacts of physical climate risk – already unprecedented in scale – are set to rise in the period to 2050 regardless of global efforts to reduce carbon emissions. This has profound implications for people’s lives and livelihoods, the global economy and financial stability.

Within the financial sector, exposure to physical risk will vary based on the location and nature of operations and the composition of portfolios. Risks can be both direct and indirect, spreading through sectors, countries and value chains.

The ClimateWise physical risk framework demonstrates the relevance of insurance industry modelling tools and expertise in understanding the longer-term climate impacts on real estate lending and investment portfolios. Crucially, the framework highlights the role of adaptation in managing these risks.

The framework provides an illustrative analysis from 12 real estate portfolios with a total market value in excess of £2 trillion. The analysis considered both 2C and 4C warming scenarios and results suggest that: 

• The number of UK residential properties at risk of flooding could rise by up to 40 per cent by 2050 and the associated Average Annual Loss (AAL) could more than double.
• Losses are likely to be geographically clustered with disproportionate losses in more exposed areas.
• UK commercial property assets will also experience increased losses of up to 70 per cent.
• Property portfolios outside the UK exposed to tropical cyclone risk could experience losses of up to 80 per cent.
• In all cases property-level adaptation has the potential to offset a significant proportion of these losses.

The ClimateWise physical risk framework offers a practical guide to how investors and lenders can apply the same methods and tools as insurers to understand their own exposure to physical risk.

The ClimateWise transition risk framework   

Transition risks are those that arise as the economy shifts towards a low or zero carbon model. Technological innovations and evolving policy will have consequences – both positive and negative – for organisations affecting asset values and the costs of doing business. 

The ClimateWise transition risk framework supports investors and regulators to assess how the transition to a low-carbon economy will affect the financial performance of infrastructure investments – a significant asset class exposed to transition risk. 

The ClimateWise transition risk framework is an open source model and accompanying guide designed to support investors in understanding their exposure. The framework is a practical tool for Chief Investment Officers, asset managers and owners, regulators and the wider financial community. The framework comprises three steps designed to enhance understanding of: 

1. Transition risks and opportunities at the portfolio level
2. The impact of transition risk on specific assets
3. Financial modelling analysis enabling the quantification of potential impact on asset returns 

As the ClimateWise transition risk framework is open source it allows users to cross check the assumptions behind the outputs and adapt in house models according to the results.

About ClimateWise 

ClimateWise is a global network of leading insurers, reinsurers, brokers and industry service providers who share a commitment to reduce the impact of climate change on the insurance industry and society. It is a voluntary initiative driven directly by its members and facilitated by the University of Cambridge Institute for Sustainability Leadership (CISL).

For more information, please contact Dr Bronwyn Claire - bronwyn.claire@cisl.cam.ac.uk