Physical climate risk to test limits of diversification - Fitch

Increases in the frequency and severity of extreme environmental conditions will test the limits of risk diversification over the coming decade, according to Fitch Ratings.

It points out that Ice storms in Texas in 1Q21 have led to severe credit impacts on local power utilities, underlining the speed at which physical climate risks can have a financial impact – even on entities with previously healthy profiles.

Large asset owners, such as pension funds and insurers, are increasingly scrutinising the exposure of their investments to physical climate risks.

Fitch believes the use of scenario analysis as a risk-management tool will rise, with strong support from central banks. 

Nonetheless, for pervasive, systemic risks such as climate change the options for risk diversification may be limited, it warsn.

This increases the importance of ex-ante risk mitigation through collaboration between the public and private sectors on adapting assets and infrastructure to climate change and developing blended finance mechanisms that can offer targeted reductions in insurance premiums for activities that show evidence of risk mitigation.

More extreme weather

Physical climate risks can be acute, such as storms, or chronic, for example, drought. Both types of risk are expected to worsen over the coming decade, posing risks to companies and assets, supply chains and economic growth.

Insurance coverage is likely to expand to address these risks, expects the rating agency, but underinsurance remains a significant challenge. Two-thirds of damages from extreme weather in 2020 were uninsured, it points out, and sectors and regions with particular exposure are often lacking in coverage.

The potential for supply-chain disruption is also growing, with many complex products, such as battery metals and microprocessors, having high exposure to regions of significant physical climate risk. 

Companies with strong internal coordination and contingency planning will be better placed to respond to these shocks, which can have credit impacts ranging from severe to manageable, concludes Fitch.