"Everyone's realizing that the physical risks are becoming much more apparent," says analyst at Ortec Finance
As Canada continues to navigate the impacts around wildfires and poor air quality, climate experts at Ortec Finance are warning that these risks could have hefty implications on pension portfolios.
Notably, what was once a discussion largely centered around transition risks like the impact of decarbonization on fossil fuel-heavy portfolios is now focused on the physical manifestations of climate change and their long-term implications for institutional investors.
“Physical risk,” as defined by Bert Kramer, head of climate research at Ortec Finance, includes both acute and chronic categories. Acute risks refer to extreme weather events and not the type of volatility investors have traditionally experienced, but those expected to become more severe or frequent due to climate change.
Contrastingly, chronic risks play out over longer time horizons and are tied to slow-moving environmental changes. These include falling agricultural productivity and reduced labour capacity as more regions face sustained heat and drought.
“It’s not about what we've been used to in the past but how more severe can we expect this to be in the future?” he said, while also acknowleding the disconnect between how climate risk is being assessed by different expert communities.
While economists tend to take a more optimistic view of global warming’s financial consequences, climate scientists are generally more pessimistic, he said. Yet market valuations both in equities and corporate bonds often lean heavily on the economists’ outlook. If the scientific community’s warnings are more accurate, that could trigger severe repricing.
"If climate scientists are actually right, and things get much worse than what mainstream economists currently believe, this has major ramifications for valuations, and therefore we could expect major market price corrections. I think that is at a very high level the story," said Kramer.
Tijmen Janssen, climate risk analyst at Ortec Finance, pointed to the growing focus on physical climate risk as a reflection of the world’s failure to stay on track with earlier climate goals.
“Every year, the goals that we've set a couple of years ago are further out of reach,” he said, which makes the prospect of a higher-warming future increasingly likely. As a result, the industry’s attention is gradually shifting away from transition risks and toward the more immediate and long-term consequences of physical climate impacts.
He also highlighted the growing body of scientific research around climate tipping points. Thresholds that, once crossed, could trigger irreversible changes in the earth’s systems. Janssen believes that these findings could further amplify both warming and the physical risks that come with it.
Janssen noted a clear shift in how institutional investors, notably in Canada are approaching climate risk. While much of the focus in recent years was on decarbonization and reducing financed emissions, attention is now turning toward the more immediate and longer-term implications of physical climate risks.
“Everyone's realizing that the physical risks are becoming much more apparent,” he said.
This shift is particularly relevant in the Canadian context, where pension funds tend to have significant exposure to private assets. With longer lock-in periods and extended investment horizons, these portfolios are especially vulnerable to risks that may unfold gradually over time. Janssen observed that Canadian pension managers are beginning to incorporate climate risk assessments earlier in the investment process.
He pointed to the growing use of highly detailed modeling tools that can assess climate impacts like flooding down to a granular level, which helps investors understand not just direct exposure but also broader systemic risks.
Still, Janssen acknowledged that while there’s no single solution yet, there’s still a clear and growing trend among Canadian pension funds to integrate physical risk into the full investment decision-making process.
However, he emphasized the most important step is to start integrating it into every stage of the investment process.
“At least incorporating a view and a degree of climate risk in the decision-making process, in the monitoring and active engagement” is what Ortec recommends to clients, he said.
He noted that some investors are already accounting for physical risks in their pricing models, adjusting the value of deals based on potential future climate impacts, whereas others may not factor it in at all, which raises questions about long-term exposure.
Nevertheless, he emphasized that building climate resilience into expected cash flows over the holding period is key, and that taking this first step is essential for long-term portfolio stability.
Janssen outlined two main channels through which physical climate risks can impact assets; one direct, the other more systemic. The first is straightforward where “the extreme weather can affect your building, and that’s going to cost you money, because you’re not able to produce anything as a company,” he noted.
Whereas the second, less visible threat comes through the insurance market. In regions like the US, where climate risks are escalating, insurability is becoming a major concern.
“Premiums are skyrocketing,” Janssen said. “If insurance skyrockets, or maybe even excluded from certain regions, that means that market valuations will surely be impacted."
Kramer ultimately warns that pension funds need to recalibrate their expectations when it comes to future returns, especially in the context of rising climate risk. Given that outlook, he urged funds to be more conservative. Not just in their return assumptions, but also in the level of risk they’re taking on.
“Across most scenarios, returns going forward will probably be somewhat lower than what we’ve seen in the past,” he noted.
To maintain long-term financial health, Kramer argued pension plans should aim to align their strategies with climate outcomes that limit warming.
“Ultimately, the best option is to stick as close as possible to two degrees warming,” he said.
While he acknowledged the difficulty of that path, noting that from a political standpoint, “it’s currently extremely challenging,” he said.
