Physical climate risk moves from ESG debate to enterprise value risk

One lens to approach physical climate risk is not as an ESG question, but as a valuation question. The issue is not whether a company has made the right public commitments, or whether it sits neatly inside a sustainability label.

The sharper investment question is whether its assets, revenues, supply chains and financing costs are properly priced for a world in which weather disruption is becoming a more material operating risk. This is the central message from Pzena Investment Management’s latest research on Physical Climate Risk, which frames the issue in explicitly financial terms.

“Physical climate risk presents a potential threat to corporate value, with implications for companies and investors.”

By tracking where these risks materialise, companies can adapt their businesses, while investors can better assess resilience at both company and portfolio level.

Understanding each on its own terms matters because physical climate risk is different from transition risk. Transition risk captures the impact of policy, regulation, consumer behaviour and economic change as markets move toward a lower-carbon economy. Physical risk is more direct. It refers to the tangible effects of a changing climate on assets and operations.

Pzena adopts the TCFD (task force on climate-related financial disclosures) distinction between acute and chronic physical risk. Acute risk is event-driven, including hurricanes, floods, wildfires and cyclones.

Chronic risk emerges more gradually, through rising temperatures, sea level rise and other long-term shifts in climate patterns. Both categories matter because both can affect company earnings, asset values and balance-sheet strength.

Enterprise value-at-risk

The framing of enterprise value-at-risk moves the conversation away from broad climate rhetoric and into the language of company analysis.

Physical climate risk can affect enterprise value in several concrete ways. For example: stranded assets, devaluation and assets becoming uninsurable. Higher costs of goods and services. Pressure on capital ratios for banks and insurers, reduced financing availability, lower production and weaker revenue.

That list should be familiar territory for advisers and investment committees. The financial consequences are concrete. Extreme weather can shut an industrial facility and cut revenue. A real estate asset that becomes harder to insure loses valuation. A bank concentrated in high-risk regions faces rising credit risk.

When companies must spend more on logistics, insurance, cooling or flood protection, margins follow. The evidence in the Pzena paper is deliberately company specific. Gildan Activewear, for example, temporarily shut distribution operations in the Carolinas after Hurricane Florence in 2018.

In November 2020, Hurricanes Eta and Iota forced the temporary closure of its manufacturing hub in Honduras and Nicaragua because of flooding and power outages. Pzena estimates the company incurred losses in the tens of millions of dollars.

BASF SE, the German chemicals group, provides another example. Around 2018, extremely low water levels in the Rhine River, caused by drought and high temperatures, disrupted operations by limiting the transport of raw materials and products. BASF reported losses of approximately €200 million to €250 million due to decreased production and increased logistics costs.

These are not theoretical modelling exercises. They are examples of physical risk moving through logistics networks, production capacity and operating costs, then landing in earnings.

From exclusion to due diligence

The takeaway is not that companies exposed to physical climate risk should simply be excluded. That would be too blunt. The more useful conclusion is that exposure must be understood, priced and monitored.

Pzena’s sector framework identifies several areas where physical climate risk may emerge first because of the nature of the underlying operations:

• Utilities and energy face potential damage to power plants, grids and pipelines, reduced generation capacity from drought or heat, heat stress on equipment and coastal infrastructure risk.
• Agriculture faces crop loss, soil erosion, livestock mortality and pests.
• Real estate faces property damage, higher insurance costs, asset devaluation and the possibility of some assets becoming uninsurable.
• Industrials, financials, chemicals and healthcare all carry their own exposures through facilities, borrowers, supply chains and operating continuity.

A case study in adaptation

Pzena notes that agriculture has absorbed approximately one-quarter of all economic losses from climate events, with developing regions hit most heavily.

The Barry Callebaut, a cocoa asset, example shows how a manager can recognise physical risk without automatically walking away from the company. Barry Callebaut operates in West Africa, where changing weather patterns and unpredictable cocoa harvests carry real investment risk.

Pzena says the company’s adaptation work, particularly its support for agroforestry in the cocoa supply chain, helped inform its investment view. Agroforestry can protect cocoa plants from excessive heat, support soil health and provide farmers with multiple revenue streams.

The paper concludes: “Exposure to physical climate risk did not preclude us from investing in Barry Callebaut because we were comfortable with the company’s approach to mitigation and adaptation.”

Perhaps this is the key point of investing in this current environment. Physical climate risk does not need to be framed as a moral screen. It can be framed as an investment risk that requires better questions: who oversees it, how does it affect capital allocation, which risks remain hard to manage, what data gaps exist, and what indicators show whether adaptation is working?

The advice opportunity is to make this discussion more disciplined. Climate risk is often presented as a values issue, but for diversified portfolios it is increasingly a valuation issue. The companies that understand their exposure, invest sensibly in adaptation and preserve operating resilience may deserve different treatment from those that simply hope the next flood, fire, drought or heatwave lands somewhere else.