A Deep Dive into the Evolving Physical Risk Landscape
In our previous post, we discussed the emergence of carbon as a financial asset, which creates a framework for measuring, managing, and pricing climate risk. In this post, we take a look at the emerging physical risk landscape.
The Big Picture: Extreme weather conditions are on the rise
The effects of climate change are here. The IPCC report has established that emissions from human activity are causing temperatures to rise, and in turn leading to more extreme weather (severe heat waves, wildfires, excessive rainfall, and flooding).
Extreme weather events as a result of climate change are becoming increasingly frequent, exposing assets to physical, and interconnected risk. Natural disasters as a result of climate change have cost the world a whopping $313 billion in 2022 alone.
However, things are beginning to change
There is growing consensus amongst stakeholders (Governments, Regulators, Central banks, investors, activists, and consumers) on the urgent need to move towards net zero. Concerted efforts are being made to build an ecosystem which will fast track this journey, but there is still a lot to do.
One of the key drivers for change is growing regulatory pressure. There is now considerable pressure on businesses from consumers and investors for greater disclosure of climate risks. Regulators are driving more stringent disclosure requirements on climate risks for Banks and Financial institutions. The EU Taxonomy and Sustainable Finance Disclosure Regulation (SFDR) are bringing greater transparency to sustainable investments. The Task Force for Climate related Financial Disclosures (TCFD) has helped to create a standardized format for climate related disclosures. These efforts are cascading to financial institutions and impacting businesses at the ground level.
The much-needed shift from voluntary to mandatory disclosure will drive business enterprises to undertake a more comprehensive assessment of climate risk exposures and help put in place a risk management strategy to adapt to the changing environment. Extreme weather events are likely to get worse before they get better, even as emissions are reduced. The world therefore needs to adapt and develop better ways to manage climate risk. We expect the landscape to evolve rapidly over the next few years.
Modeling risk exposure using climate intelligence
AI driven risk assessment models. Any parameter that is not being measured cannot be managed. Measurement and quantification is therefore the first step to build a strategy for managing climate risks.
Historical data and traditional risk assessment techniques are of limited value in assessing and managing future climate risk. Startups focussed on climate intelligence are building advanced risk assessment models, combining machine learning and AI with traditional weather modeling techniques, and using real time data from alternate sources (satellites, radars and IOT sensors) to offer forward looking predictive analytics. These companies are working on a wide range of solutions which include the following elements.
- Assessment and quantification of risk
- Scenario analysis and stress testing
- Resilience and mitigation strategy
- Regulatory reporting
Players: ClimateX, founded in 2020 uses AI based physical risk models to run multiple scenarios to predict extreme weather events and determine the impact to physical assets before the damage occurs. Cervest, leverages data and AI to facilitate measurement and management of climate risks at an asset level. Other companies that have built AI/ML risk assessment models include Jupiter Intelligence, Climavision and Sust Global.
While most companies position themselves as a one stop shop for managing climate risks, modeling risk exposures including interconnected risks at an asset level could be an elaborate and complex exercise, particularly for global businesses where the value chain is spread across geographies.
Here are some operating challenges related to physical risk modeling
- Verticalized versus horizontal solutions: Risk exposures tend to be unique to individual businesses. The solution for an automobile manufacturer with manufacturing units across geographies, dependent on a global supply chain for thousands of components would be vastly different to a utility or a company in the oil and gas sector. A climate intelligence model therefore becomes a tailor made solution built around the context and nuances of specific industry verticals and business enterprises, which requires expertise across the risk spectrum and multiple areas of specialization.
- Institutional sales cycles: Another concern is long enterprise sales cycles. Climate intelligence providers need buy-in from multiple stakeholders that requires considerable education along the way slowing down the overall rate of adoption.
- Productized solutions: Complexity at the ground level across industry verticals, extended business development cycles and the need to build specialized expertise are challenges to attaining scale.
Several climate intelligence startups have been acquired by banks and financial institutions, which have strategic interest in building technology driven risk assessment expertise.
Covering climate risks; insurance solutions
The availability of cost-effective insurance solutions is a crucial element in building a robust ecosystem for management of climate risks. Traditional insurance has limitations both in terms of capacity and pricing when it comes to covering climate risks. Aon has estimated a massive $171 billion gap in climate insurance capacity.
Innovative underwriting models based on real time data from a variety of sources powered by AI/ML engines enable insurers to structure covers with greater alignment to risk exposures and efficiency in pricing. Parametric insurance triggers payouts in response to occurrence of predefined thresholds of temperature, rainfall and other weather-related parameters. Such covers could play a useful role in complementing traditional indemnity insurance.
Players: Paris based Descartes offers parametric insurance for a range of climate-related risks using an underwriting model based on machine learning and data from alternative sources. Arbol, another insurer offering parametric insurance for climate risk, uses smart contracts on the Ethereum blockchain to issue its insurance policies. This enables Arbol to automatically pay out claims in less than two weeks. Demex, built a tech platform for climate intelligence has partnered with Vave, an underwriting managing agent, to create a unique and innovative parametric insurance product for extreme temperature conditions. The insurance cover is designed to automatically provide immediate cash when predefined temperature conditions are achieved without going through a time-consuming loss adjustment process. The product therefore helps to bridge the gap before conventional insurance claim proceeds are paid.
The opportunity
The physical climate risk landscape is evolving rapidly and these are some trends that we expect to see.
- Growing demand for climate intelligence services: Pressure from regulators and consumers will drive businesses and stakeholders to build a strategy for managing physical climate risk. We expect this trend to significantly expand demand for climate intelligence and related services.
- Use of AI and alternative data: In the near term, we expect to see a lot more startups leveraging AI to better measure, manage and report physical risk.
- Verticalization: Given the complexity across industry verticals, we may see companies positioning themselves as specialists in specific industry verticals. We are also likely to see niche climate intelligence providers with specialized focus on a specific risk (heat stress, wildfire etc.) come up.
- Differentiation: We see companies differentiating themselves based on technology, granularity of data, industry focus and price.
- Growth in insurance capacity: Currently, there is a huge gap in insurance capacity requiring additional risk capital. We expect this space to attract a large number of new players, given the significant growth in expected demand and large risk exposures. We see new players offering parametric covers, leveraging technology driven underwriting models to deliver more effective risk coverage at competitive pricing.
- Interest from Strategic players: Strategic acquisitions by players provides added impetus to startup activity in this space and also impacts the strategic positioning of startups.
If you are a like minded investor, early stage company building or thinking about opportunities at the intersection of fintech and climate risk, we at Illuminate would love to chat with you. Feel free to reach out to me at ss@illuminatefinancial.com
Illuminate Financial is a thesis-driven enterprise fintech venture capital fund looking to partner with companies building technology solutions for financial services.
