Environmental exposures will test diversification capabilities – Fitch

Increases in the frequency and severity of extreme environmental conditions will test the limits of risk diversification over the coming decade, with supply chains stressed to breaking point.

In a new report Fitch Ratings warned physical climate risks such as storms, or drought are expected to worsen over the coming decade, posing risks to companies and assets, supply chains and economic growth.

The report, ‘ESG in Credit – Exposure to Environmental Impact Issues’, added insurance coverage is likely to expand to address these risks, but underinsurance remains a significant challenge, with two-thirds of damages from extreme weather in 2020 uninsured, and sectors and regions with particular exposure often lacking coverage.

It warned the rising natural peril threats create the potential for growing supply-chain disruption, with many complex products, such as battery metals and microprocessors, having high exposure to regions of significant physical climate risk.

“The Covid-19 pandemic has highlighted the fragility of many global supply chains, alongside increasing supply chain disruption from natural disasters and environmental hazards,” said the report. “Companies with well-developed internal coordination and contingency planning will be best-placed to respond to these shocks, which can have impacts ranging from manageable to severe.”

Ice storms in Texas in 1Q21 have led to severe credit impacts on local power utilities, underlining the speed at which physical climate risks can have a financial impact – even on entities with previously healthy profiles, Fitch added. Large asset owners, such as pension funds and insurers, are increasingly scrutinising the exposure of their investments to physical climate risks and we believe the use of scenario analysis as a risk-management tool will rise, with strong support from central banks.

“Around two thirds of damages from extreme weather incidents in 2020 were uninsured, with gaps in insurance coverage mostly in countries with high exposure to natural catastrophes,” said the report. “This reflects an ‘adverse selection’ phenomenon, where property owners opt out of coverage because of rising premiums despite heightened exposure, which drives up premiums further.”

Fitch said the concern is that for pervasive, systemic risks such as climate change the options for risk diversification may be limited. This increases the importance of ex-ante risk mitigation through collaboration between the public and private sectors on adapting assets and infrastructure to climate change and developing blended finance mechanisms that can offer targeted reductions in insurance premiums for activities that show evidence of risk mitigation.

“Diversification is the mainstay of most investment strategies to mitigate physical climate risk, but with projected increases in both the frequency and severity of extreme weather conditions and other environmental hazards, this will be tested to the limit in the coming decade,” said David McNeil, Associate Director, Sustainable Finance, Fitch Ratings

“Around two thirds of damages from extreme weather incidents in 2020 were uninsured, with gaps in insurance coverage mostly in countries with high exposure to natural catastrophes,” said the report. “This reflects an ‘adverse selection’ phenomenon, where property owners opt out of coverage because of rising premiums despite heightened exposure, which drives up premiums further.”

Fitch explained both public and private sectors are historically more inclined towards pay out of rebuild costs after events than risk mitigation. However, the systemic risks posed by climate change will increasingly require property owners, banks, non-bank financial institutions, insurers and governments to collaborate in risk[1]mitigation.

“This will open the door to blended finance mechanisms and targeted premium reductions for projects that can show evidence of risk mitigation,” it added.

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