Vulnerability models are a key part of climate-related physical risk analysis; they model the response of a particular asset type to a particular climate-related hazard.
Rising temperatures due to climate change, for example, will impact people and animals in different ways — meaning that the impact of global warming will vary from a workforce-based industry to one that relies more on animal productivity, like livestock farming or aquaculture.
Climate impact functions help investors and companies price the climate-related physical risks across their different asset types in order to make informed decisions to manage those risks.
One of the key tools in climate-related physical risk analysis are vulnerability models, also sometimes called damage functions or impact functions. These models connect the severity of a specific physical hazard to financial impact, including revenue, operating expenses and capital expenditures.
The specific ways a given climate hazard could have a financial impact on an asset type are known as impact pathways. For example, as global warming leads to higher average temperatures around the world, business assets across geographies and industries will face negative impacts to their operations. To model the impact function of very high maximum temperatures at a manufacturing facility, one possible impact pathway would be the reduction of the productivity of employees who are working inside the facility.
However, different types of assets respond to the same hazard in different ways, which means that taking a bottom-up risk analysis requires separate vulnerability models for many different asset types.
For instance, in the above very high maximum temperatures example, human productivity responds differently than animal productivity. Therefore, for investors and companies exposed to different asset types — for example, manufacturing facilities versus livestock or aquaculture farms — it’s important to assess how very high temperatures impact productivity for each asset type. This helps investors and companies price in the climate-related physical risk across their portfolios and make informed decisions to manage those risks.
Let’s have a closer look at how humans and different animals show different vulnerability to heat stress in terms of impact functions.
Exposure to heat stress impacts a person’s ability to regulate their internal body temperature, which in turn raises the risk of heat stress or heat stroke. Heat-related illness could result in a decline in work and productivity. S&P Global Sustainable1 has built the impact pathway of reduction in employee productivity based on a global study of the effects of heat on working populations and Intergovernmental Panel on Climate Change data. This impact pathway demonstrates that workforce productivity is projected to decrease by 1.14% per 1 degree C increase in average daily maximum temperature under a linearity assumption.
Animals, however, do not have the same tolerance threshold to increasing temperature as humans. For example, salmon fish have biological and environmental criteria that must be fulfilled to make farming possible. If the water is warmer than 16 degrees C, salmon become stressed, eat less and experience reduced growth. The mortality rate can increase when temperature exceeds 20 degrees C. To model an appropriate impact pathway, S&P Global Sustainable1 has developed an impact function that simultaneously and comprehensively considers the direct impact of heat stress on salmon feeding and weight growth, as well as the indirect impact of lack of oxygen on salmon health. The model also considers the mortality rate above a certain temperature threshold.
The resulting impact function for salmon fish growing in coastal aquaculture (placed in shallow water lagoons) is a non-linear curve that shows less impact on salmon productivity compared to the human productivity curve up to a 9 degrees C increase in average daily maximum temperature. At or above a 10 degrees C increase in average daily maximum temperature, however, salmon productivity was more impacted than human productivity.
Another example is the impact of higher temperatures on the egg production of layer chickens. A chicken's thermoregulatory mechanisms for avoiding heat stress are normally activated above 24 degrees C. We have built two models for this impact, one for non-climate-controlled and another for climate-controlled farms, to assess the rate of decrease in egg production as a function of absolute change in average daily maximum temperature. The impact function for climate-controlled farms shows less impact than non-climate-controlled farms, and both show less impact in comparison to the impact function curve developed for human productivity.
Climate control systems in poultry farms can keep the temperature 10 degrees C to 15 degrees C cooler than outside, according to research from the National Bank of Pakistan. That means a 10 degrees C increase in average daily maximum temperature can still impact egg production even in air-conditioned facilities.
These examples show that if an investor owns different asset types across their portfolio, or if a bank has exposure to loans in different industries, they can carefully assess the different impacts of hazards on different assets to understand what financial risks they entail. Vulnerability models help companies and businesses to quantify, assess, manage and disclose their climate-related financial risk.