Climate Physical Risk Assessment in Asset Management

Climate-related phenomena are increasingly affecting regions worldwide, manifesting as floods, water scarcity, and heat waves, which can significantly impair companies' assets and productivity. We develop a framework, based on the Vasicek model for credit risk, that introduces downward jumps due to climate phenomena in a company asset's dynamics. These negative shocks are designed to mirror the negative effect of extreme climate events. We explore various possibilities for the distribution of jumps and provide a comprehensive characterization of the model and its calibration process that relies on companies' asset intensity and geographical exposure. We utilize this new multivariate firm value model framework with jumps to understand the influence of climate related extreme events on different portfolios' expected and unexpected losses. The results suggest introducing additional safe capital to offset the losses resulting from physical climate risks, particularly for high asset intensity sectors.