Section 6 – Due diligence phase

Module 8 – Physical risk assessment

Physical risk assessment is an essential pillar of climate risk management for FIs. As climate impacts and regulatory scrutiny intensify, all institutions – regardless of size or maturity – must develop foundational capabilities to identify, assess and respond to physical climate risks. Applying core principles means organisations can approach this task in a structured, credible and actionable way. A critical first step is gathering accurate location data associated with lending portfolios.

• Core principles for physical risk assessment

  Proportionality

  Not all loans, projects or portfolios require the same level of scrutiny. The assessment should be tailored to the exposure size, level of risk, level of regulatory requirements and the organisation’s internal capacity and maturity.

  Forward-looking perspective

  Because future climate change impacts may differ from historic trends, institutions should use credible climate model projections and reference scenarios to assess how risks could evolve over the lifetime of assets or loans.

  Documentation and continuous improvement

  Institutions should recognise and record any data or knowledge gaps and document the reasoning behind key decisions. Regular reviews of the assessment approach are encouraged to incorporate new data, methods and lessons learned.

The following terms are often used when assessing physical climate risk within an organisation.

• Physical climate risk terms

  Exposure

  The presence of people, assets or operations in locations that could be affected by climate-related hazards.

  Sensitivity

  The extent to which an asset or business is affected when exposed to a hazard.

  Vulnerability

  The degree to which an asset or system may suffer harm due to exposure and sensitivity, moderated by its ability to cope (see adaptive capacity).

  Adaptive capacity

  The ability of an asset, borrower or community to adjust, cope or reduce potential damages from climate impacts. Including adaptive capacity in assessments helps translates gross climate risk into net climate risk.

  Likelihood

  The probability of a specific climate hazard occurring in a particular place or timeframe.

  Severity

  The magnitude of impact if a hazard occurs.

Guidance 6a: Physical Climate Risk Equation

Guidance 6a visualises the equation climate risk analysts use to calculate exposure of an asset to physical risk.

• Begin with quick wins and high-level assessments

  • Start by systematically recording the location and sector of each asset or borrower.
  • Use hazard maps from local authorities or other credible sources to flag high-risk areas.
  • Apply checklists or questionnaires to screen for known vulnerabilities.
  • Prioritise sectors and locations historically affected by climate events as ‘hotspots’.

• Build channels for expertise and escalation

  • For transactions flagged as potentially high-risk, draw on partnerships and engage with investors, other FIs, and consultants
  • Establish clear escalation protocols and, where risks are uncertain, encourage staff to seek additional review rather than ignoring potential issues.

• Institutionalise documentation and continuous learning

  • Promote a culture of learning, especially from front-line employees who may gain valuable real-world insights from regular contact with local communities.
  • Keep straightforward records of flagged risks, decision-making rationale and positive or negative outcomes, to support monitoring, evaluation and learning.
  • Use insights to refine and improve the screening process over time.

• Foster agility and resourcefulness

  • Make use of open-source data and peer networks. For example, this post lists 70+ publicly available resources for climate risk assessment.
  • Build partnerships with other institutions in emerging markets that face similar challenges and explore opportunities to collaborate on addressing mutual data and capacity gaps.

Key goals and outcomes from a physical risk assessment

As part of due diligence, a physical risk assessment should identify and evaluate climate-related hazards that could materially affect a project’s viability, value and or debt serviceability. This informs the level of risk associated with a client or project and informs management actions. Each assessment should aim to address the following goals:

• Goals

  Identification of material hazards

  Pinpoint the project’s site-specific forward-looking physical risk profile over its lifecycle, covering both acute and chronic risks.

  Assessment of gross asset vulnerability

  Evaluate how operations, equipment, infrastructure and supply chains could be affected if hazards materialise.

  Consideration of asset-specific adaptive capacity

  Address existing protection measures such as defences, insurance, contingency planning, and access to buffer funds. Identify opportunities for financing asset-level enhancements to adaptive capacity (see Guidance 7).

  Quantification of potential financial impact

  Estimate the possible effects on cash flows, asset value, collateral quality and debt serviceability. Use these insights to inform provisioning, pricing and loan terms based on risk level

  Support informed credit decision-making

  Add comprehensive risk metadata to project files for audit trail, ongoing client engagement and portfolio-level reviews. Flag high-risk projects for further due diligence or inclusion of adaptation measures in financing agreements.

  Enhance bank-client relationship

  Encourage open dialogue with borrowers by focusing on the long-term sustainability of both the project and the relationship.

  Maintain stakeholder confidence

  Show compliance with regulatory requirements and best practice expectations, helping to protect the institution’s reputation and license to operate.

Key outcomes to expect from a physical risk assessment:

• Clear risk classification: each project is assigned a documented risk rating for relevant physical hazards.
• Decision-useful insights: insights are summarised clearly, highlighting the main risks, supporting rationale and recommended mitigation actions for inclusion in the credit proposal package.
• Actionable recommendations: specific next steps for mitigation, monitoring or escalation based on criteria such as breaches of materiality thresholds.
• Portfolio-level aggregation: insights from individual project assessments consolidated into broader portfolio management, concentration monitoring and strategic planning (see Module 20).

This process should ultimately deliver actionable insights for credit decision-making, risk mitigation and regulatory compliance – helping to achieve the following:

• Avoid unforeseen loan losses linked to climate hazards
• Direct financing towards resilient, future-ready projects and clients
• Strengthen the rigour, credibility and compliance of the credit approval process

Guidance 6b: Example information flows during asset-level physical risk assessment

Effective physical risk assessment relies on good quality, relevant data and produces clear, usable outputs for decision-making.

Critical inputs include:

1. Asset location data: Start with the best available information, while recognising that greater precision improves the accuracy of the physical risk assessment. GPS coordinates for assets are ideal, but use the most specific location data available, for example, postcode rather than city, district or province rather than country. Capture the addresses of the productive assets, not just the client’s corporate head office.
2. Sector and economic activity of client, project or asset.

Guidance 6b offers a step-by-step process for assessing as potential transaction and reaching a decision on whether to flag it for potentially high exposure to physical risk.

However, the validity of a physical risk assessment depends on the quality of the input data, the availability of scientific model projections and the approach used to translate input data into decision-useful outputs.

• Consider the following caveats:

  Data quality and availability

  Gaps in historical records, outdated asset information or limited client disclosures can reduce the accuracy of assessments.

  Scenario and model uncertainty

  Climate modelling and projections contain inherent uncertainties, especially when applied at higher levels of granularity. Results should be interpreted as indicative, not definitive.

  False precision

  Avoid presenting results with excessive levels of accuracy, for example, “37.2 per cent risk of flood in 2040”. Instead use broader risk bands, such as high, medium, low, and present results as ranges.

  Third-party model transparency

  Avoid relying on ‘black-box’ models that do not clearly disclose methodologies, assumptions or data origin.

Guidance 6c: Example output from an asset-level physical risk assessment

Typical outputs from a physical risk assessment should include an overall risk rating for all relevant climate hazards across relevant time horizons, accompanied by a practical summary and recommended next steps. Guidance 6c shows an example output from a transaction-level physical risk assessment designed to support an institution in deciding whether to proceed with financing a project and under what conditions.

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