Physical risk: Turning climate uncertainty into investment insight
As climate pressures reshape energy, food and water systems, physical risk is becoming more financially material, and integrating data, governance and adaptation into investment strategies is now essential. Here, the Global Equity team at Federated Hermes outline their approach to assessing physical risk – at both a company and portfolio level – and the related opportunities.
Physical risk, like artificial intelligence (AI), presents both an opportunity and a threat. Climate change is reshaping the systems that underpin energy, food and water, with growing financial consequences for businesses. Many companies continue to pursue year-on-year growth without sufficient planning, readiness or adaptation – leaving them increasingly exposed.
Practical investment opportunities in climate and nature-based solutions remain limited, but companies must factor environmental considerations when setting long-term strategies. Initially this begins with understanding the macroeconomic implications of rising climate uncertainty and identifying vulnerabilities across operations and supply chains. For investors, increasingly granular data is enabling more informed investment decisions, including the ability to quantify potential disruptions to logistics and operations.
When assessing physical risk, three factors matter most: exposure, resilience, and transition. Climate resilience has become the dominant theme and is closely aligned with Sustainable Development Goal (SDG) 13 on Climate Action, while resilience and transition increasingly focus on adaptation.
Looking ahead to 2026 and beyond, broader systemic risks and the social dimensions of adaptation – often framed through the lens of a ‘just transition’ – are set to become higher priorities for investors and companies alike.
In practice, physical risks materialise within the market in three main areas: operational risk, supply chain disruption and wider market or systemic risk. Exposure can be evaluated by analysing country or regional footprints, including revenue sources, manufacturing locations and interactions with natural ecosystems. As biodiversity becomes more financially material, investors are gaining clearer insights into how nature-related impacts can affect a company’s long-term financial performance.
What are physical risks?
Physical risks can be broadly divided into acute and chronic hazards.
- Acute hazards are extreme, short-term events such as storms, hurricanes, cyclones, floods and wildfires.
- Chronic hazards develop over time and include rising temperatures, drought, desertification and long-term changes to precipitation patterns.
These hazards have wide-ranging economic impacts. They affect commodity availability, which includes seafood and agricultural products, contribute to inflationary pressures, and increase operational costs. For example, higher temperatures drive up energy costs for cooling buildings, while climate-related disruptions can reduce the availability of key agricultural inputs.
Capital-intensive sectors are particularly vulnerable to these risks, as their reliance on physical assets limits flexibility compared to more asset-light businesses. At the same time, the severity and frequency of catastrophic climate events continues to rise, as reflected in recent insurance claims and loss statistics (see Figure 3)
One area where physical risks are materialising rapidly is within food systems. Shocks to agricultural inputs are increasingly disrupting the supply chains of consumer goods companies and food and beverage retailers. As a result, security of supply and supply chain resilience have become top board-level priorities. Despite some improvement to supply chain resilience following Covid-19 and subsequent trade disruptions, many companies still have significant scope to be more strategic – mitigating these imminent risks and therefore reducing the need for a purely reactive approach.
How do we assess physical risk?
Our approach begins with monitoring company and portfolio-level exposure. We have developed proprietary tools – the ESG Dashboard and the ESG Portfolio Monitor – which enable detailed analysis of relevant ESG metrics across our holdings.
When assessing physical risk, we place strong emphasis on quantitative data to support qualitative analysis. Given the limited availability of detailed financial data on climate-related impacts, we use models to estimate exposures and apply scenario analysis to test resilience.
While the materiality of physical risks to individual company sites or products is often fairly static in the short term, the broader trend points towards increasing significance as climate uncertainty intensifies over the long term.
Our analysis incorporates our proprietary Quantitative Environmental (QE) Score within company valuations. This captures key indicators such as the quality and scope of Environmental Management Systems (EMS) reporting, Task Force on Climate-Related Financial disclosures (TCFD) , and CDP (formerly the Carbon Disclosure Project) reporting, all of which address physical risks and the related opportunities.
The QE Score quantifies the financial effects of sustainability risks and opportunities, embedding both risk mitigation and value creation opportunities into our scoring framework. Company-specific scores allows for integration into financial analysis and valuations. We believe that companies exceeding industry median levels of environmental risk integration – or demonstrating meaningful improvement – are well positioned to outperform over the long term.
From a qualitative perspective, we also track how physical risks feature in engagement activities and conversations. Using our EOS at Federated Hermes Limited1 large language model (LLM), we tag and analyse meeting notes to identify relevant discussions. In 2025, physical risk was raised in eight engagements with portfolio holdings, which helped to provide valuable insight. You can read more about the proprietary EOS LLM .
When assessing physical risk, we place strong emphasis on quantitative data to support qualitative analysis.
Portfolio-level metrics
We use a range of portfolio-level metrics to assess physical risk exposure. These indicators show that the portfolio is underexposed to physical risk relative to the benchmark, reflecting our focus on solid, long-term fundamentals and companies with good and improving ESG practices.
The Trucost environmental impact ratio provides an estimate of a company’s environmental footprint, by measuring its total natural‑capital impact per unit of economic value. It incorporates factors such as carbon emissions, water use, waste, pollution and natural resources depletion, and offers a single, normalised metric of environmental intensity per unit of revenue. On this basis, the portfolio’s footprint represents just 1% of the MSCI ACWI benchmark footprint. For context, the MSCI World also has a lower environmental footprint than the ACWI benchmark at only 17%.
Sustainalytics assess physical climate risk management across a broad universe of companies. As at the end of December 2025, the portfolio scores 49 compared with a benchmark score of 46, on a scale where 100 represents universal adoption of strong physical risk management practices. High-scoring holdings include companies in sectors with high materiality such as utilities and semiconductor manufacturers.
Direct indicators, such as water stress exposure, also provide valuable insights and have good coverage across the portfolio. Using MSCI data, the portfolio has a weighted score of 3.28, compared with a benchmark score of 3.78, indicating lower exposure to water stress. This assessment reflects both geographic locations of operations and the product footprints of these companies.
Analysis of this data, alongside other indicators such as exposure to fragile ecosystems, shows that physical risk within the portfolio is concentrated within specific holdings. Approximately 22% of the portfolio derives more than 80% of its revenues from areas with high climate-related exposure.
The portfolio maintains an exposure to emerging markets, although we remain marginally underweight relative to the MSCI ACWI benchmark. Emerging Asia, in particular, continues to face elevated physical climate risks. Our positioning in the region is typically capital light, although we gain some indirect exposure through financial institutions. Given this risk profile, we prioritise robust disclosure of strategy and governance over site-level breakdowns. Where material gaps are identified, we engage with companies to encourage enhanced reporting.
Both qualitative assessments and quantitative data are essential to building a more comprehensive understanding of physical risk exposure.
From a top-down perspective, we also apply an EOS climate framework that categorises sector-level exposure to physical risk as high, medium or low. For example:
- High: Utilities
- Medium: Materials, Energy, Real Estate
[We have an underweight position to the four sectors listed above in aggregate: -3.16, absolute 8.2 versus 11.35, as at 31 December 2025]
Focus on industry characteristics
Beyond direct exposure to physical risks, we assess industry-level exposure to climate and transition-related policies using the EOS climate framework. This analysis highlights sectors such as energy, utilities, industrials and financial services as having elevated exposure to climate and transition policy risks, with material implications for both direct and indirect investment exposure.
Translating climate insights into financial action requires converting climate intelligence into practical investment decisions. By combining climate analytics with market data, we can quantify exposures, price risk appropriately and integrate climate-adjusted metrics directly into portfolio strategy.
The Taskforce on Nature-related Financial Disclosures (TNFD) reporting provides a consistent framework for companies to report nature-related risks, mirroring the role played by TCFD in climate risk disclosure. As nature becomes increasingly central to value creation across supply chains, the materiality of these risks will continue to grow. However, relatively few companies currently provide detailed reporting on their direct and supply chain exposure to physical risks, which are often embedded in the value chain and therefore less visible. For investors, improved TNFD reporting enhances transparency around corporate actions and progress, providing an essential input for forward-looking analysis.
Conclusion
With the severity and volume of extreme climate-related events expected to rise in line with global temperatures over the next few decades, the need for companies to manage their exposure to physical risk has become vital.
Through a range of portfolio-level and company metrics and our focus on engagement – leveraging EOS at Federated Hermes, our dedicated stewardship arm – the Strategy has demonstrated lower exposure to physical risk versus the benchmark, reflecting our focus on solid, long-term fundamentals and companies with good and improving ESG practices. Over the long term, we believe that companies exceeding industry median levels of environmental risk integration – or demonstrating meaningful improvement – are well positioned to outperform.
For more information on Global Equity ESG.
Global Equity ESG, Annual Report 2025
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This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Any investments overseas may be affected by currency exchange rates.
1 EOS at Federated Hermes Limited (EOS): A pioneer and provider of effective stewardship. Founded in 2004 on a legacy dating back to 1983, EOS provides investors worldwide with the following services: engagement, voting, public policy advocacy, responsible investment policy advice, and portfolio screening.
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