Asset-Level Climate Physical Risk Assessment and Cascading Financial Losses

Abstract

We develop a methodological framework for asset-level climate physical risk assessment that connects for the first time asset-level information (financial, extra-financial and climate), to firms’ revenues, macroeconomic dynamics, financial valuation and investor’s risk. We combine the acute and chronic impacts of climate change. Shocks on physical assets are translated into adjustments in the financial valuation of the equity contracts by means of a Climate Dividend Discount Model, and then into an adjustment of investors’ Expected Shortfall. We apply the methodology to the assessment of cascading risk for European investors who hold equities of firms that have assets located in Mexico and exposed to hurricanes. Results confirm the importance of the asset-level approach for financial risk assessment. While expected annual impacts of chronic risk at sector level are generally low (-1.29% on average), important shocks emerge when we consider acute impacts on individual assets, and higher return periods (RP), reaching up to -13.07% for RP 250.
In addition, the Expected Shortfall of the investor increases considerably up to -12.48% for RP 250. Thus, comprehensive asset-level physical risk assessment should be a main concern for investors and financial supervisors.

Keywords: Geolocalized physical assets, climate physical risk, cascading losses, equity holdings, Climate Discount Dividend Model, Expected Shortfall.

JEL Classification: G00, G32, Q54