Physical climate risk from the asset up
A new tie-up between Morningstar Sustainalytics, Veridion and XDI aims to provide investors with asset-level transparency around physical climate exposures. Alicia White, Rochelle March and Karl Mallon explain
Environmental Finance: Morningstar Sustainalytics has announced a collaboration with XDI and Veridion to further develop your physical climate risk product. What is the thinking behind the tie-up?
Alicia White: We’re seeing a real shift in thinking around physical climate risk, moving from data built for and well suited to disclosure, and the integration of physical risk into investors’ external reporting, to data that can also support investment decisions.
That requires identifying which assets are really driving specific physical climate risks, understanding how material those risks are, and then translating that into financial metrics.
Asset transparency was one of the strongest messages that we heard from the market over the past couple of years, so we have chosen to work with XDI and Veridion: collaborators who own each layer of the data that feeds into that.
EF: What roles will the three companies play in the collaboration?
Rochelle March: At Veridion, we supply the geolocation and business intelligence layer needed to help map companies to their physical assets and operations globally. Identifying company locations has been quite challenging – with perhaps a headquarters or a select list of known locations that you'd get from a government registry or a filing. It is often very hard to find all of a company’s locations – it can be a very extensive process.
Our approach is to use AI to collect all publicly available documents, such as filings, as well as digital signals, such as job descriptions, social media, map pins, etc. What's unique about that is we can capture the operational locations where people are employed and what they’re making at that location. That level of operational detail is a lot more valuable than just a legal location, which may be just a PO box or a non-occupied office that's there for legal purposes. When it comes to climate risk, that's a huge distinction, because if a storm hits a non-occupied legal address, that's inconsequential.
Karl Mallon: Veridion’s intelligence connects directly to XDI's physical asset models. We provide asset-level hazard impact analysis through our engineering-based Climate Risk Engines. These combine sub-asset design and construction material data, models for hazards such as flood, fire and cyclone, and forward-looking climate scenarios to project how climate hazards will change, all of which translates into projections of damage and operational disruption.
What is pioneering about our approach at XDI is that our models reflect the physicality of each asset. When was it built? How high is it above the ground? What kind of materials can we expect it to be made of, and are they resilient? So, instead of using ‘vulnerability functions’ which are based on experience of how, for example, an average commercial building in the US might behave in a flood or a hurricane, we have a digital twin for that specific type of building and each of its major components. These can be adjusted to the building standards in any country. This is a dramatic improvement upon ‘average behaviour’ techniques when applied to the specific data Verdion can provide.
AW: At Morningstar Sustainalytics, we pull this granular underlying data into decision-useful insights through our own research framework. We can marry the potential impact of physical climate risks with a company’s financial position – its balance sheet, cash flows, etc. – to understand how financially resilient it would be to a major disruption.
EF: What outputs will the product provide to investors?
AW: We'll have a couple levels of data. Top-line metrics at the company level will assess the financial impact through multiple different lenses, such as different scenarios, tail-risk percentiles, hazards, geographies, etc. It will also drill down to the top material assets at the portfolio level, and what the level of materiality is for each asset. From that, investors will be able to look at a company and see, for example, that these are the top 20 most relevant assets to the company’s business model that are exposed to these 11 different hazards across these four different scenarios, under different return-period expectations, across different time horizons, and so forth.
We’re developing data that can be usable in the existing workflows of a portfolio manager or analyst – such as valuation, stress testing, etc. It’s about building metrics that can be plugged into a discounted cash flow or valuation model, rather than something that sits as a separate report.
EF: How do you expect investors and companies to use this data?
KM: What we want to try to do is get more scrutiny into the market, especially at the asset level. This isn’t a black box: instead, users can unpack the data, drill down into it, audit it, confirm they understand what’s going on, and build confidence in the data and models. This is important, because our analysis is showing that differences are emerging between companies in terms of how they are managing physical climate risk. But it’s not a name-and-shame exercise. This is an opportunity to understand the underlying exposures companies have to physical risks.
Things like the Palisades fire in Los Angeles, the floods in Valencia in Spain, and black rain events in Asia are proving to be wake-up calls. This goes beyond ‘tick and flick’ reporting – it’s about facts and physics. We’re seeing climate physical risk move beyond being a sustainability issue to a risk management issue, and a threat to capital assets and to business interruption. Investors are realising that if they haven't got their eye on this ball, they’re missing a trick.
Alicia White is director of climate and nature solutions at Morningstar Sustainalytics, Karl Mallon is the founder and head of science and technology at XDI, and Rochelle Marsh is head of GTM and speciality data sets at Veridion. For more information, see: www.sustainalytics.com/investor-solutions/climate-solutions/physical-climate-risk-metrics
