Underprepared companies in the crosshairs of physical climate risks

2024 was the first year that world average surface temperatures exceeded the symbolic threshold of +1.5°C above pre-industrial levels¹, an ambitious target set back in 2015 during the Paris Climate Agreements. With this precipitous increase in average temperatures, the world is more likely on track for warming at just below 3°C levels, bringing as a result, a plethora of damaging consequences. Notably, the frequency and severity of physical risks associated with climate change are projected to increase. Events such as wildfires, floods, droughts, tropical cyclones, and heat and cold waves, have caused around $300bn of economic losses in 2024², with trends far exceeding the pace of inflation. As an example, over the last 15 years, insured losses from severe convective storms have increased at an annual rate of 8%, with inflation only accounting for around 1/4^th of the increase and 1/8^th being directly attributable to climate change³.

Due to the range and diversity of climate events, few areas around the world will be spared. As an indication of their impact on global wealth, in a world where transition efforts are made in line with Net Zero by 2050 commitments, physical risks impart a 3% hit to global GDP⁴ (2050-2100). Actual transition effort trends suggest the impact on global GDP would reach 4-5% (2050-2100)⁴, going far beyond this in worst case scenario modelling. Conclusions are that physical climate risks will put inflationary pressures on economies and are forcing companies to reckon with the increasing threat these events pose. In this short piece, we explore how they impact company fundamentals, the current measures allowing companies to adapt to their effects, and which industries are best positioned to face these challenges.

At their core, company revenues are a function of volume and price. These are dependent on various factors, but especially important is having: a healthy customer base, a productive workforce, dependable plant property and equipment (PP&E), and available raw materials. Physical climate risks will impact all of these. The Oil and Gas activities in the Gulf of Mexico and adjacent Louisiana processing and refining plants give a taste of this. Each time hurricanes pass through the region, crude oil extraction in the Gulf is depleted due to forced shut downs, the impact on local workforce, and ensuing damage to offshore and onshore infrastructure.

Representation of Hurricane impact on Crude Oil Production in the Gulf of Mexico

Climate loss events will be covered under a policy linked to Business Interruption or Property insurance, allowing businesses to recoup the value lost through inactivity or damaged property. However, quite worryingly, due to poor risk management practices, rising premium costs, or the large imbalance between excess demand and lack of supply for these complex insurance products, most businesses operating in these at-risk areas do not protect their revenues against these adverse climate events. Estimates show that the protection gap for climate related events has increased significantly over the last few years reaching 55% of total climate related losses (~$160bn)⁵.

A company’s cost of goods sold (COGS), operating expenses, and capital allocation priorities will also be impacted. As noted previously, cost of insurance is increasing in at-risk areas, however this only represents a fraction of the potential cost inflation emanating from physical climate risks, with other parts of the pie being costs relating to energy and infrastructure. Energy usage for companies will increase to combat heat and cold waves. Under a 3°C warming scenario, a country’s longest heat wave will on average be 24.5 days, with more than 16% of the world’s largest cities exposed to heat waves lasting more than a month every year⁶. Similar trends are explored on the other end of the thermometer, where cold snaps are becoming more unpredictable, putting additional strain on power markets in the winter. Achieving climate-resilient infrastructure through new builds, upgrades, or retrofits is projected to cost between $140-300bn by 2030 and $280-500bn by 2050⁷. This includes projects like making water and electric utilities more robust or integrating flood defence systems.

As a result of this, from a fundamentals standpoint, companies with operations in impacted areas should see a drop in profitability driven by lower than projected revenues and higher than anticipated costs. This impacts growth perspectives for companies, having to inefficiently reallocate capital to ensure these perceptions are reversed.

One way to limit the impact of such events on a company is to simply start avoiding areas which will exponentially face harsher operating environments due to climate change. Diversification away from at-risk areas is key to weather the volatility and uncertainty these events will incur on output and profitability. A recent survey of US based executives showed that efforts are already going in this way, with a quarter of respondents confirming that parts of their operations had already been relocated due to climate change concerns⁸. However, this is not always possible, especially when dealing with fixed assets like commodities, large cities, or industries with historically established hubs. This paves a way for a rise in adaptation solutions, with associated costs outlined previously. Unfortunately, a large portion of companies still do not have a strategy to tackle these, or alternatively are not prioritising it enough. In latest studies, less than half of companies with climate adaptation strategies are implementing them in the next 10 years⁹.

Climate adaptation strategy timelines across companies

With all of this in mind, drawing conclusions on singular companies depends on a case-by-case basis, however, broader winners and losers are identifiable. Equipment and support services providers to utilities, agriculture, energy, and manufacturing sectors should benefit from the push for climate-resilient infrastructure. The engineering, procurement, and construction (EPC) industries and certain types of building material and system manufacturers, like insulation and HVAC (heating, ventilation, air conditioning), will particularly benefit from this trend. On the opposite end, companies with undiversified and unprotected exposure to at-risk areas could face the largest losses. Vicious circles bringing additional supply chain bottlenecks for key industries and systemic risks to the insurance sector are not to be discounted. The threat posed by physical climate risks are requiring long term investors to become educated with the knock-on effects of climate change.