Physical Climate Risk Disclosure Framework

REGULATORY SPOTLIGHT Physical Climate Risk Disclosure Requirements: From TCFD to ISSB Evolution of Physical Risk Disclosure Standards The journey toward comprehensive physical climate risk disclosure began with the Task Force on Climate related Financial Disclosures (TCFD) in 2017. While the TCFD's four-pillar framework—governance, strategy, risk management, and metrics and targets—addressed both transition and physical risks, early adoption focused predominantly on transition risk. Physical risks received less attention, partly due to the complexity of assessing geographically dispersed, long-term physical hazards and the limited availability of high-quality climate data and modeling tools.

This imbalance has shifted dramatically. The intensification of extreme weather events, mounting insurance losses, and growing evidence of chronic climate impacts have elevated physical risk from a secondary concern to a primary disclosure priority. The International Sustainability Standards Board's IFRS S2 Climate-related Disclosures, issued in June 2023 and effective from January 1, 2024, represents the culmination of this evolution—establishing physical climate risk disclosure as a mandatory element of investor-focused sustainability reporting.

IFRS S2 Physical Risk Requirements: A Technical Deep Dive IFRS S2 builds on the TCFD recommendations while providing significantly more granular requirements for physical climate risk assessment and disclosure. The standard requires entities to disclose information about climate-related risks and opportunities that could reasonably be expected to affect cash flows, access to finance, or cost of capital over the short, medium, or long term.

Defining Physical Climate Risks IFRS S2 classifies physical climate risks into two categories: Acute Physical Risks: Event-driven risks resulting from increased severity and frequency of extreme weather events, including: Tropical cyclones, hurricanes, and typhoons Floods and storm surges Wildfires Heatwaves and cold snaps Droughts Heavy precipitation events Chronic Physical Risks: Longer-term shifts in climate patterns that may cause sustained impacts, including: Rising mean temperatures Sea-level rise Changes in precipitation patterns and water availability Ocean acidification Biodiversity loss and ecosystem degradation Permafrost thawing Changes in agricultural productivity Core Disclosure Requirements Under IFRS S2, entities must disclose:

1. Governance: How the board and management oversee climate-related risks, including physical risks. This includes governance processes for monitoring physical risk exposure, the frequency of reporting to the board, and how physical risk considerations are integrated into overall risk management and strategic planning.

2. Strategy: How physical climate risks affect business model, strategy, and financial planning. Entities must disclose:

Current and anticipated physical climate risks identified through risk assessment processes How identified physical risks affect business model and value chain Current and anticipated effects of physical risks on financial position, performance, and cash flows Climate resilience of strategy and business model, including scenario analysis How physical risks inform capital allocation and strategic decisions

3. Risk Management: Processes for identifying, assessing, and managing physical climate risks. This includes:

Methodologies for identifying acute and chronic physical risks How entities assess magnitude and Likelihood of physical climate impacts Prioritization of physical climate risks relative to other risks Monitoring of physical risk exposure over time Integration with enterprise-wide risk management processes

4. Metrics and Targets: Metrics used to assess and manage physical climate risks, including:

Exposure to physical climate risks (e.g., percentage of assets in high-risk locations) Cross-industry metrics relevant to physical risk (where material) Industry-specific metrics (drawing from SASB Standards) Climate-related targets, including adaptation and resilience targets Progress against targets and how achievement is measured Scenario Analysis for Physical Risks A critical innovation in IFRS S2 is the requirement for climate-related scenario analysis to assess resilience of strategy and business model. For physical risks, scenario analysis must consider: At least one scenario aligned with limiting global warming to 1.5°C above pre-industrial levels At least one scenario that explores outcomes based on current trends or policies Time horizons appropriate to entity-specific circumstances, typically extending to 2050 or beyond for physical risks Entities must use scenarios consistent with latest scientific consensus, such as those developed by the Intergovernmental Panel on Climate Change (IPCC) or the Network for Greening the Financial System (NGFS). The analysis should explore how acute events and chronic shifts might affect operations, supply chains, markets, and financial performance under different warming pathways.

Relief Provisions and Implementation Challenges Recognizing the complexity of physical risk assessment, IFRS S2 provides certain reliefs: Qualitative information may be provided where quantitative assessment is not feasible without undue cost or effort First-year scenario analysis relief allows entities time to develop analytical capabilities Simplified disclosure for smaller entities, subject to jurisdictional decisions Regional Regulatory Approaches to Physical Risk Disclosure European Union: CSRD and ESRS The EU's Corporate Sustainability Reporting Directive (CSRD), effective from January 2024, takes a "double materiality" approach, requiring disclosure of how climate change (including physical risks) affects the company and how the company affects climate change. The European Sustainability Reporting Standards (ESRS) E1 on Climate Change requires detailed disclosure of: Physical climate risks identified through materiality assessment Exposure to key physical risks (heatwaves, droughts, floods, sea-level rise, etc.) Adaptation plans to address identified physical risks Financial implications of physical risks and adaptation measures Metrics for monitoring physical risk exposure and adaptation progress The July 2025 revised ESRS exposure drafts maintained focus on physical risk while reducing overall reporting burden by 57%, demonstrating EU commitment to physical risk disclosure balanced with proportionality concerns.

United Kingdom: Transition Planning and Physical Risk While the UK abandoned plans for a Green Taxonomy in July 2025, it has maintained focus on physical climate risk through ISSB-aligned disclosure requirements. The UK Sustainability Disclosure Standards (SDS), expected to align closely with IFRS S1 and S2, will require physical risk disclosure from large companies and listed entities. The UK Transition Finance Council's guidance emphasizes that credible transition plans must account for physical climate impacts on business continuity and resilience.

United States: Paused but Present Although the SEC's climate disclosure rule faces legal challenges and implementation uncertainty, state-level requirements continue advancing. California's SB 253 and SB 261, though amended in September 2024, require covered entities to disclose climate-related financial risks, including physical risks, starting in 2026. Several other states have proposed similar requirements, ensuring physical risk disclosure remains on the US corporate agenda despite federal headwinds.

Asia-Pacific: Rapid Adoption The Asia-Pacific region has emerged as a leader in ISSB adoption: Australia: The Treasury Laws Amendment Act, effective September 18, 2024, introduced ISSB-aligned climate disclosures for large companies, with first reports due in 2026. Given Australia's exposure to bushfires, droughts, floods, and cyclones, physical risk disclosure is particularly salient.

Singapore: While extending timelines in August 2025 for smaller companies, Singapore maintains commitment to ISSB-aligned standards, with particular focus on physical risks relevant to a low-lying island nation facing sea-level rise and extreme heat.

Hong Kong: Voluntary adoption of ISSB standards began in August 2025, with mandatory requirements expected by 2028. The Hong Kong Taxonomy for Sustainable Finance Phase 2A, launched in September 2025, includes climate change adaptation as a distinct environmental objective.

Japan: Has signaled intention to adopt ISSB standards, with physical risk disclosure particularly relevant given exposure to earthquakes, typhoons, and sea-level rise.

Emerging Markets: Bridging Disclosure and Development Many emerging markets face acute physical climate risks while having limited institutional capacity for sophisticated risk assessment. Mexico introduced sustainability standards effective January 2025 for certain private companies. Brazil, Costa Rica, Nigeria, and Sri Lanka are adopting or piloting ISSB standards, recognizing that physical risk disclosure is essential for attracting climate-resilient investment.

Scenario Analysis and Forward-Looking Assessments A defining feature of modern physical risk disclosure is the requirement for forward-looking, scenario-based analysis. This represents a significant departure from traditional financial reporting's focus on historical performance and near-term projections.

Scenario Selection and Design Effective physical risk scenario analysis requires:

1. Scientific Foundation: Scenarios must align with latest climate science, typically drawing from IPCC Assessment Reports. Representative Concentration Pathways (RCPs) or Shared Socioeconomic Pathways (SSPs) provide standardized temperature trajectories.

2. Geographic Granularity: Physical risks are inherently location-specific. Analysis must consider asset-level or facility-level exposure rather than relying solely on country or regional averages.

3. Time Horizons: Physical risk manifests over decades. Scenario analysis should extend to at least 2050, with many entities analyzing impacts through 2100 for long-lived assets or infrastructure.

4. Acute and Chronic Integration: Scenarios must capture both sudden shocks (e.g., 100-year flood becoming 10-year flood) and gradual shifts (e.g., sustained temperature increases affecting productivity).

Key Challenges in Physical Risk Scenario Analysis Data Availability: High-resolution climate hazard data, particularly for emerging markets and specific locations, remains limited.

Model Uncertainty: Climate models involve significant uncertainties, especially at local scales and for specific extreme events.

Cascading Impacts: Physical risks ripple through supply chains and interdependent systems, creating complex, non-linear effects difficult to model.

Long Time Horizons: Traditional corporate planning typically spans 3-5 years, while physical risk analysis requires 30-100 year perspectives.

Monetization: Translating physical impacts into financial effects involves assumptions about adaptation costs, asset replacement, revenue disruption, and market responses.

The Path Forward: Toward Standardized, Comparable Disclosures As physical risk disclosure transitions from nascent practice to regulatory requirement, several priorities emerge: Improving Data and Tools: Enhanced climate hazard mapping, asset-level exposure data, and accessible modeling platforms are essential for widespread, high-quality disclosure.

Capacity Building: Many companies, especially smaller entities and those in emerging markets, require support in developing physical risk assessment capabilities.

Assurance and Verification: As disclosure becomes mandatory, third-party assurance of physical risk assessments will be critical for credibility and comparability.

Integration with Financial Reporting: Physical risk disclosure must increasingly connect to financial statements, with material impacts reflected in asset valuations, provisions, and going-concern assessments.

The evolution from TCFD's recommendations to ISSB's requirements marks a fundamental shift—physical climate risk disclosure has moved from voluntary good practice to core element of corporate reporting. As regulation continues maturing globally, the focus is shifting from whether to disclose to how to disclose with rigor, consistency, and decision-useful granularity.

Central Banks and Physical Climate Risk: Stress Testing and Supervision Central banks and financial supervisors have emerged as critical actors in physical climate risk assessment, moving from conceptual frameworks to operational stress testing and active supervision. The recognition that physical climate impacts threaten financial stability and macroeconomic performance has driven central banks to develop sophisticated analytical frameworks and incorporate physical risk into regulatory oversight.

The NGFS Framework: Global Standard for Physical Risk Assessment The Network for Greening the Financial System, comprising 141 central banks and supervisors representing over 88% of global greenhouse gas emissions, has established itself as the authoritative source for climate scenario analysis in financial supervision.

NGFS Phase V Scenarios: Enhanced Physical Risk Modeling Released in November 2024, NGFS Phase V represents a step-change in physical risk assessment. Key enhancements include: New Damage Function: Incorporating latest climate science, the Phase V damage function captures climate impacts beyond simple temperature increases. It assesses persistent effects on economic productivity, labor capacity, agricultural yields, infrastructure functionality, and human health. The function is calibrated using state-of-the-art climate datasets, providing more accurate estimates of physical risk across geographies.

Expanded Geographic and Sectoral Coverage: Phase V provides granular physical risk projections for over 160 countries and numerous economic sectors, enabling financial institutions to assess location-specific and industry-specific exposure.

Integration of Acute and Chronic Risks: While previous vintages focused primarily on chronic risks (temperature increase, sea-level rise), Phase V better integrates acute hazards. The Climate Impact Explorer provides data on tropical cyclones, floods, droughts, heatwaves, and wildfires.

Updated Climate Commitments: Scenarios incorporate national climate commitments as of March 2024, reflecting the evolving global policy landscape.

NGFS Scenario Narratives and Physical Risk NGFS scenarios explore three broad pathways, each with distinct physical risk profiles:

1. Orderly Scenarios (Low Physical Risk): Net Zero 2050 and Below 2°C scenarios assume early, coordinated climate action limiting global warming to 1.5°C or below 2°C. Physical risks are relatively constrained, with moderate increases in extreme weather frequency and limited chronic impacts. However, even in these scenarios, significant adaptation investment is required.

2. Disorderly Scenarios (Medium Physical Risk): Delayed Transition and Divergent Net Zero scenarios assume late or inconsistent policy action. While transition risks are elevated due to abrupt policy shifts, physical risks are also higher than orderly scenarios. Delayed action allows additional warming and ocean acidification, increasing both acute hazard frequency and chronic impact severity.

3. Hot House World Scenarios (High Physical Risk): Current Policies and Nationally Determined Contributions (NDCs) scenarios assume insufficient climate action, leading to 2.5°C to 3°C+ warming by 2100. Physical risks dominate, with dramatic increases in extreme weather, severe chronic impacts including potentially catastrophic sea-level rise, ecosystem collapse, and widespread agricultural disruption. Economic damages escalate non-linearly, potentially reaching 30% of GDP by 2100, with tail risks approaching 50%.

NGFS Short-Term Scenarios: Capturing Near-Term Physical Shocks In May 2025, the NGFS published its first short-term scenarios, covering 3-5 year horizons. These scenarios specifically address the challenge that long-term climate pathways (2050-2100) have limited relevance for near term risk management, capital planning, and monetary policy.

Short-term scenarios model: Acute Physical Shocks: Near-term extreme weather events (e.g., severe hurricane season, multi-year drought, devastating wildfire season) and their immediate economic and financial impacts.

Financial System Amplification: How physical shocks transmit through financial markets, affecting credit availability, asset prices, insurance capacity, and bank solvency.

Policy Responses: Central bank and government responses to acute climate events, including emergency lending, disaster relief, and ad-hoc adaptation measures.

The short-term scenarios enable financial institutions and supervisors to analyze physical risk on timelines relevant to credit cycles, strategic planning, and regulatory capital requirements—a critical gap in previous long-term only frameworks.

Critical NGFS Note: Phase V Physical Risk Methodology Users should be aware that the academic paper (Kotz et al., 2024) underpinning Phase V physical risk estimates has been retracted following academic critique. While this affects certain variables (integrated physical damages scenarios, some GDP estimates), other Phase V outputs, the Climate Impact Explorer acute hazard data, and all previous NGFS phases remain unaffected. The NGFS continues to represent best available practice, but users should interpret Phase V physical risk estimates alongside broader uncertainties inherent in climate-economic modeling. The NGFS plans to update scenarios again in 2026, incorporating refined physical risk methodologies.

European Central Bank: Leading Physical Risk Integration The European Central Bank has positioned itself at the forefront of central bank physical climate risk supervision.

ECB Climate Stress Testing The ECB's climate stress tests, conducted on significant institutions across the eurozone, incorporate comprehensive physical risk scenarios: 2022 Economy-Wide Climate Stress Test: Analyzed impact of physical risks (temperature rise, floods, droughts, wildfires) on corporate profitability and creditworthiness. Findings revealed that physical risks could reduce corporate profitability by 10-15% in high-warming scenarios, with material implications for bank loan portfolios.

2024-2025 Stress Testing Cycle: Incorporated enhanced physical risk modeling, including: Asset-level exposure analysis for real estate and infrastructure loans Supply chain disruption modeling for manufacturing and agriculture Insurance exposure and reinsurance capacity under extreme weather scenarios Interconnectedness between physical risks and market risks (e.g., repricing of climate-exposed assets) Climate Factor in Collateral Framework (July 2025) The ECB's July 2025 announcement of a "climate factor" in its collateral framework represents a watershed moment. Starting in H2 2026, the climate factor will reduce the value assigned to marketable assets pledged as collateral by non-financial corporations based on exposure to climate-related uncertainties, with physical risk a key component.

This mechanism: Creates direct financial incentive for corporations to address physical climate exposure Integrates climate risk into core monetary policy operations Signals that climate risk is not merely an ESG consideration but a prudential concern affecting financial stability Bank of England: Climate Biennial Exploratory Scenario (CBES) The Bank of England launched its Climate Biennial Exploratory Scenario in 2021, with the first exercise completed in 2022. While transition risk dominated initial analysis, subsequent iterations have progressively emphasized physical risk.

CBES Physical Risk Components The Bank of England's scenarios explore physical risks through: Chronic Impacts: Effects of rising temperatures, sea-level rise, and changing precipitation on UK property values, agricultural productivity, and infrastructure resilience. Analysis reveals that coastal properties and flood prone regions could experience significant valuation declines.

Acute Events: Modeling of extreme weather impacts, including severe flooding (building on UK's 2007 and 2013-2014 flood experiences), heatwaves affecting labor productivity and energy demand, and windstorms disrupting operations and damaging assets.

Cross-Border Exposure: UK financial institutions' exposure to physical risks in international portfolios, particularly in emerging markets vulnerable to extreme weather and chronic climate shifts.

Key Findings and Supervisory Implications CBES exercises have revealed: Physical risks materialize earlier and more severely than transition risks in delayed action scenarios Insurance sector faces particularly acute challenges, with potential for reduced coverage availability and affordability in high-risk areas Real estate portfolios show significant vulnerability, especially coastal and flood-plain properties Agricultural lending exposed to productivity declines and extreme weather disruption The Bank of England has translated findings into supervisory expectations, requiring firms to demonstrate robust physical risk assessment, scenario analysis, and strategic adaptation planning.

Federal Reserve: Climate Scenario Analysis Pilot The Federal Reserve's approach to physical climate risk has been more cautious than European counterparts, but momentum is building. The Climate Scenario Analysis Pilot, announced in 2022 with results published in May 2024, involved six of the largest US banks.

Pilot Exercise Structure The exploratory pilot focused on: Physical Risk Scenarios: Two scenarios exploring acute and chronic physical risks, including extreme weather event frequency, sea-level rise impacts on coastal assets, and temperature-related productivity effects.

Sectoral Focus: Concentrated on residential and commercial real estate lending, where geographic exposure to physical hazards is most direct and material.

Data and Methodology Challenges: The pilot explicitly aimed to identify gaps in data, analytical tools, and institutional capacity for physical risk assessment.

Key Takeaways The Fed's pilot revealed: Data Limitations: Banks struggled with granular, asset-level climate hazard data, particularly for geographically dispersed portfolios.

Modeling Complexity: Translating physical hazards into credit risk parameters (probability of default, loss given default) proved challenging, given limited historical precedent for future climate conditions.

Time Horizon Challenges: Banks' traditional 1-3 year credit models are misaligned with 30-100 year physical risk timescales.

Opportunity for Enhancement: Significant scope exists for improving methodologies, data infrastructure, and cross-functional collaboration (risk management, strategy, operations).

While the pilot was exploratory and non-binding, it signals Fed recognition that physical climate risk is material to US financial stability. Future exercises are expected to be more rigorous and potentially integrated into capital adequacy assessments.

Basel Committee Principles for Climate Risk Management In June 2024, the Basel Committee on Banking Supervision formally incorporated climate risks into the Basel Core Principles for effective banking supervision. Physical climate risks are now explicitly recognized as potentially material risks that regulators and banks must identify and address.

Basel Committee Principles on Physical Risk The principles require: Risk Identification: Banks must have processes to identify physical climate risks relevant to their portfolios, geographies, and business lines.

Risk Assessment: Banks should assess magnitude and Likelihood of physical climate impacts using scenario analysis and forward-looking methodologies.

Governance and Oversight: Board and senior management oversight of physical climate risk as part of overall risk governance.

Capital Adequacy: Supervisors should assess whether banks hold adequate capital given their physical climate risk exposure, potentially requiring additional capital buffers in high-risk cases.

Disclosure: Banks should provide transparent disclosure of physical climate risks and risk management approaches, aligned with international standards (IFRS S2, TCFD).

The Basel framework provides global minimum standards, ensuring that physical climate risk supervision becomes standard practice across all internationally active banks.

Emerging Practices and Future Directions As central bank physical risk supervision matures, several trends are emerging: Granular Exposure Mapping: Moving from portfolio-level estimates to asset-by-asset, location-specific physical risk assessment using GIS mapping, satellite data, and advanced climate models.

Dynamic Risk Monitoring: Real-time tracking of physical hazard events and portfolio exposure, enabling rapid response to emerging risks.

Adaptation-Aware Supervision: Evaluating not just exposure but also adaptation measures undertaken by borrowers and counterparties, potentially differentiating capital treatment based on resilience investments.

Cross-Border Coordination: Enhanced coordination among central banks to address physical risks in globally interconnected financial systems, particularly for systemic risks from simultaneous climate events across regions.

Integration with Macroprudential Policy: Exploring whether physical climate risks warrant macroprudential interventions, such as geographic lending limits, enhanced capital requirements for climate-exposed sectors, or mandated insurance coverage.

The integration of physical climate risk into central bank supervision represents one of the most significant evolutions in financial regulation since the 2008 financial crisis. As climate impacts intensify and scenarios become reality, central banks' role will only grow more critical in safeguarding financial stability in an era of accelerating physical climate risk.