Methodology
Last updated
Last updated
This document outlines the methodology for translating climate physical risk into financial impacts.
The insurance cost component calculates the expected annual increase in flood and fire insurance to help asset managers price in future increases in insurance premiums today.
As the frequency and intensity of acute climate hazards increase, the expected damage, or the increases over time, leading to an increase in an insurer's loss ratio (premiums earned that an insurance company pays out in claims and other expenses).
The increase in loss ratio is then translated into higher insurance premiums and will be borne directly by the customers. By understanding the risk of an asset today and the projected risk in the future, we can then calculate the estimated insurance premium at any future period with the following formula:
Where Pt is the projected premium in the future period t, L is the average Loss Ratio of insurance underwriters, and MDR is the projected mean damage ratio.
In practice, to avoid pricing in short term fluctuations due to volatilities in climate predictions, we take a 25-year interval, and we apply the method to wildfire, coastal flooding and inland flooding to obtain the annual increase of fire insurance and flood insurance for any location.
For property insurance, the loss ratio has historically been ranging from in past 10 years according to the National Association of Insurance Commissioners (NAIC). For the future insurance calculations, we assume a fixed loss ratio of 70% which is close to the 10-year average.
The utility demand component estimates the expected annual increase in heating and cooling costs experienced by an asset using the changes of cooling and heating degree days.
The cooling and heating requirement to keep occupants comfortable is expected over time due to climate change. By comparing the percentage increase (or decrease) between the cooling/heating demand of the baseline year (currently 2025) and future the future year (2050), we can then obtain the annual change of heat and cooling demand of a building.
The effective cooling demand of a location are calculated from Cooling Degree Days (CDD) which are a proxy to that measures the demand for energy to cool buildings to a comfortable temperature for its occupants. This is achieved using two different equations, with the maximum value taken as the final CDD value.
These equations reference findings from established literature and are designed to capture the increased energy demand for cooling as temperatures rise.
Heating Degree Days (HDD) are a proxy to that measures the demand for energy to heat buildings to a comfortable temperature for its occupants. The effective heating demand is calculated using a single equation derived from published literature. This equation accounts for the reduced need for heating as global temperatures rise. Studies have shown that HDDs will decrease as a result of global warming, leading to a reduction in heating energy demand.
Remediation measures are crucial to mitigate the increasing risks posed by climate change. For example, retrofitting homes to improve insulation and ventilation can significantly reduce cooling demand and enhance thermal comfort, thereby reducing energy consumption. Similarly, implementing flood defenses and fire-resistant materials can mitigate damage and lower insurance premiums.
The retrofit recommendations provide a general guideline on the retrofit expenditure required for assets to adapt to a changing climate as CapEx denominated as percentage of annual net income.
For each relevant climate risk category (i.e. Heat Stress, Flood, Fire), we find the difference of the Mean Damage Ratio between 2025 and 2050 and translate the difference to estimated CapEx based on an exponential scale of 0 - 10% as shown in the following table. In practice, the exact breakpoint is calculated dynamically for each hazard type using a min-max scaling function. For each risk category, the maximum additional CapEx is capped at 10% of income. If the asset is exposed to multiple risk categories, the additional CapEx for each risk is summed together, and can exceed 10%.
0 %
0%
10%
1%
30%
2%
50%
5%
>50%
10%
The following histogram shows the total additional CapEx for 1 million randomly selected assets around the world across all hazards. With the heavy-tail nature of the distribution, 50% of assets would experience an additional CapEx below 3.2% while highly exposed assets would require heavy investments of up to 14% in additional CapEx.
Similar to green discounts that factor in potential long term stranded asset risk and green retrofits, the climate discount rate is a long-term discount rate that factors in uncertainties brought by climate risk.
The climate discount rate is a relative metric that is calculated by projecting the overall risk profile (total mean damage ratio from all 6 climate risk categories) on a global scale. The maximum possible discount rate varies between the applied time period. Based on current knowledge, for assets exiting before 2035, the maximum possible climate discount is 75bp (0.75%); before 2050, 125bp (1.25%); before 2100, 200bp (2%).
In practice, the period of 2035 chosen for most assets with exit windows below 10 years from today.
All the metrics above can be easily incorporated into standard financial frameworks, including Discounted Cash Flow (DCF) models for climate-adjusted valuation.
The next article captures how these metrics come together to form a climate-adjusted valuation in a DCF model.
Reference for equation 1:
Reference for equation 2:
Reference for equation:
