What it means
Acute physical risk is the obvious kind: a warehouse flooded, a factory closed by a storm, a harvest lost to hail. These events hit suddenly, are often insurable, and show up in the accounts as repair costs, write offs and lost revenue.
Chronic physical risk is slower and easier to overlook. Higher average temperatures raise cooling costs and cut worker productivity, shifting rainfall patterns change which crops grow where, and gradual sea level rise makes coastal sites progressively harder to insure or sell.
The financial exposure runs well beyond a company's own buildings. A business with no assets at risk can still be badly hurt if a single supplier sits in a flood plain, if a port it depends on closes, or if its customers' incomes fall after a regional disaster.
Insurance is the usual first answer, but it is a shrinking one. Premiums in high exposure areas rise sharply, excesses climb, and in the most affected locations cover for certain perils becomes unavailable at any sensible price, which turns an insurable risk into a balance sheet risk.
Disclosure requirements have made this a board level topic rather than a facilities matter. Frameworks now commonly ask companies to describe their physical exposure under different warming scenarios and explain how it might affect the value of their assets, which forces the analysis to be written down rather than assumed.
The practical approach is unglamorous: map every significant site and key supplier by location, attach a hazard rating, estimate the loss if the event happens, and multiply by an annual probability. That gives an expected annual loss figure that can be compared directly against the cost of defences, relocation or dual sourcing.
In practice
Real-world examples.
Example
A vineyard finds that its traditional grape variety now ripens three weeks earlier than it did twenty years ago. Rather than wait, it plants 15 hectares of a heat tolerant variety as a hedge against a decade of hotter summers.
Example
A regional bank reviews its mortgage book by postcode and finds 7% of loans secured on properties in areas where flood cover is becoming difficult to obtain. It tightens lending criteria in those postcodes before the valuations start to fall.
Example
An electronics assembler discovers that both of its qualified suppliers for a critical component sit in the same typhoon exposed coastal region. It qualifies a third supplier inland, accepting a 4% higher unit price for the sake of continuity.
Think of it
“Physical risk is direct climate danger-actual weather and environmental impacts on your business.
Formula
Calculation
Expected annual loss = probability of the event in a given year x total financial loss if it occurs
Payback period on a mitigation = cost of mitigation / annual reduction in expected loss
A distribution business owns a warehouse valued at $8,000,000 on a river flood plain. Modelling suggests a serious flood would cause $3,000,000 of building and stock damage plus $1,200,000 of lost trading while operations are suspended, so total loss if it occurs = $3,000,000 + $1,200,000 = $4,200,000.
At today's flood probability of 2% a year, expected annual loss = 0.02 x $4,200,000 = $84,000.
Under a warmer scenario the annual probability rises to 5%, so expected annual loss = 0.05 x $4,200,000 = $210,000, two and a half times the current figure.
A flood defence scheme costing $1,500,000 is expected to prevent 80% of that damage, cutting expected annual loss by 0.8 x $210,000 = $168,000 a year. The simple payback is $1,500,000 / $168,000 = 8.9 years, which is comfortably inside the remaining useful life of the building.Case study
Seen in the real world.
This is a fictional, illustrative example. Calderwell Foods, an invented frozen goods producer, ran a single cold store that handled 70% of its national volume. The site was chosen decades earlier for its road links, and nobody had revisited the fact that it sat two metres above a tidal river.
A surface water flood closed the site for eleven days. Direct damage came to $2,600,000 and was largely insured, but the fictional company also lost two national supermarket listings because it could not fulfil orders, and that revenue never came back. Its renewal quote the following year carried a doubled excess and excluded flood cover on stock altogether.
Calderwell's board commissioned a site by site hazard review, invested $1,900,000 in flood barriers and raised plant, and opened a smaller second store inland so that no single site carried more than half the volume. The finance director's summary to shareholders was that the insurance payout had covered the assets but not the customers, and that only the physical changes addressed the real exposure.
Watch out
Common mistakes.
- Confusing physical risk with transition risk, when one concerns damage from the climate itself and the other concerns the cost of policy, technology and market change.
- Assuming insurance neutralises the exposure, when it rarely covers lost customers, contractual penalties or the long term fall in a site's value.
- Assessing only owned sites and ignoring suppliers, logistics routes and customer regions, where much of the real vulnerability usually sits.
Questions
People also ask.
What is the difference between acute and chronic physical risk?
Acute risks are discrete events such as floods and storms, while chronic risks are gradual shifts such as rising temperatures, drought and sea level rise.
How do companies put a number on something so uncertain?
They use scenario analysis, testing the same asset base under different warming pathways to produce a range of outcomes rather than a single false precision.
Does this matter to a small business with one location?
Arguably more, because a single site business has no ability to shift production elsewhere when that site becomes unusable.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%