The role of damage functions in assessing physical climate risks

Because physical risks are both uncertain and interlinked, one hazard can trigger cascading consequences. To better assess their exposure, investors are increasingly relying on physical risk damage functions within climate scenario modeling frameworks, to estimate potential losses and manage climate risks more effectively across both short and longer-term investment horizons. These models help them to consider not only for the potential impacts if such risks materialize, but also for how financial markets might respond to changes in the perceived likelihood of these events.

Understanding physical risk damage functions

In a simple context, physical risk damage functions quantify the relationship between climate variables, such as temperature, and resulting economic or physical damages. Different assumptions can be made about how damages evolve with rising temperatures -for example, a linear relationship implies a steady, proportional increase in damages, while an exponential one suggests that damages accelerate rapidly as temperatures rise, reflecting growing vulnerability or compounding effects.

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