Physical Climate Risk: From Hazard to Financial Impact
Physical climate risk is the potential damage that climate-related natural events can do to assets, operations and revenues: acute hazards that strike in a single event, such as flood, storm, hail, lightning, wildfire, drought and heatwave, and chronic shifts that build up over time, such as sea-level rise, changing precipitation patterns, reduced water availability and rising average temperatures. Quantifying physical climate risk in financial terms, often called financialization, means measuring that damage in currency: the chain that turns a location’s hazard score into average annual loss, probable maximum loss, lost revenue, collateral impairment or a change in a loan’s probability of default. This page walks through the chain step by step, defines the metrics, connects them to IFRS S2 and its Turkish adoption TSRS 2, to the Turkish banking regulator’s climate guidance and to the EBA disclosure standards, and shows how banks, insurers and reinsurers, corporates and real-estate owners, energy producers, data centers and municipalities use them.
On this page “financialization” means translating climate risk into balance-sheet, credit and insurance metrics; it does not refer to capital-market instruments such as catastrophe bonds or weather derivatives. The page is for information only; rely on the text of the relevant standard and regulator when determining your own reporting obligations.
Short answer: what does it mean to quantify physical climate risk in financial terms?
It means combining the hazard at a location (how often, how severe), the exposure of the asset there (what is there, what it is worth) and its vulnerability (how prone it is to damage), and expressing the result in currency as expected loss, lost revenue, asset impairment or a change in credit risk parameters. The result is not a risk score but a number that can be used directly in a balance sheet, a credit file or a policy: average annual loss and probable maximum loss for an insurer; shifts in probability of default and loss given default, and the resulting expected credit loss, for a bank; the effect on revenue, operating expenditure, capital expenditure and asset value for a company.
From hazard to financial metric: four steps
Every financial quantification follows the same chain. The links are not independent; the uncertainty of one link carries into the result, which is why the outcome is read as an amount or a range that differs by scenario and time horizon rather than as a single number.
The present and future severity and frequency of acute and chronic hazards at the location: over the observation period and under climate scenarios (middle-of-the-road and high-emission pathways), by year and by return period. The output is a location-specific hazard profile.
What is at the location: a building, a plant, a turbine, a data hall, a collateral or a loan. Its value, replacement cost, the revenue it generates and the loan it carries set the size of the exposure.
How the asset responds to the hazard: structure type, floor level, equipment layout, sector and business continuity arrangements. The same flood depth produces a different damage ratio in a warehouse and on an office floor; the same heatwave affects a data center and a hotel differently.
The combination of the three: the damage ratio becomes a loss distribution, the loss distribution becomes average annual loss and probable maximum loss; days of business interruption become lost revenue, collateral impairment becomes loss given default, cash-flow sensitivity feeds probability of default and the debt service coverage ratio. The total is read as expected credit loss and capital impact.
Acute and chronic hazards reach the balance sheet through different channels. Acute events work through the loss distribution: the event’s severity sets the damage ratio, the damage ratio sets that year’s loss, and the average and the tail are read across years. Chronic shifts work through operating expenditure, productivity and asset value trends: rising cooling load, declining water availability, shifting rainfall and rising insurance cost accumulate over time. IFRS S2 and TSRS 2 ask for the effects of both to be disclosed over the short, medium and long term.
Financial metrics: which number answers which question?
The table below collects the ten most common financial counterparts of physical climate risk. Each metric answers a different decision-maker’s question; read together, they tie an asset’s or a portfolio’s climate risk to the balance sheet.
| Metric | What it measures | Who uses it | How to read it |
|---|---|---|---|
| Average annual loss (AAL) | Expected loss per year over the long run; the mean of the loss distribution | Insurer (pure premium), asset owner, investor | The amount is not lost every year; some years nothing, some years far more. This is the average, and the basis of pricing. |
| Probable maximum loss (PML) | The loss level expected at a given return period (for example once in 100 or 250 years) | Insurer, reinsurer, portfolio manager | A return period is a probability statement: a 100-year event has roughly a 1 percent chance of being exceeded in any given year. It is the yardstick for accumulation and capital decisions. |
| Damage ratio | The share of asset value damaged at a given event severity | Engineer, insurer, valuer | The output of the vulnerability curve; AAL and PML are derived from it. |
| Business interruption | The time production or service stops after an event, and the revenue lost | Company, project finance, insurer | As important as direct damage; supply-chain and infrastructure outages enlarge the indirect effect. |
| Capital and operating expenditure impact | Adaptation investment (capex) and higher operating cost (cooling, maintenance, insurance premium) | Company, facility operator, investor | The main financial channel of chronic risk; read as a cash-flow effect spread over years. |
| Asset and collateral value | How risk is reflected in the market or collateral value of the asset | Bank, real-estate investor, valuer | An input to loss given default; read together with geographic concentration in the portfolio. |
| Probability of default (PD) | The change in the borrower’s capacity to pay | Bank | Shifts through the hazard sensitivity of the borrower’s sector; applies to all loans. |
| Loss given default (LGD) | The share lost in default because of collateral impairment | Bank | For real-estate-collateralized loans the collateral’s location is decisive. |
| Debt service coverage ratio (DSCR) | The project’s cash-flow capacity to service its debt | Project finance | Shifts through revenue and operating-cost sensitivity; prominent in energy and infrastructure projects. |
| Expected credit loss (ECL) | PD × LGD × EAD | Bank (IFRS 9), auditor | PD and LGD shifts flow directly into expected credit loss and from there into the capital adequacy assessment (RWA, ICAAP). |
Corporates and asset owners: AAL, PML, business interruption, capex
For a company, financial quantification means turning the hazard profile of each location in its facility and asset portfolio into a damage ratio, the damage ratio into average annual loss and probable maximum loss, the duration of business interruption into lost revenue, and chronic trends into adaptation investment and operating cost. The output is read per asset and in portfolio total, under today’s climate and under the selected scenarios for future years. In an IFRS S2 or TSRS 2 report this output is the quantitative counterpart of the “current and anticipated financial effects” disclosures; the standards state that quantitative information may be given as a single amount or as a range. Method and data trail must stand up to the limited assurance that TSRS reports are subject to; how that is built is explained on our TSRS climate reporting page.
The credit side: PD, LGD, DSCR and IFRS 9 expected credit loss
For a bank the same hazard profile becomes credit risk through three channels. The first is probability of default: the hazard sensitivity of the borrower’s sector (NACE) affects its cash flow and therefore its capacity to pay. The second is loss given default: the location and vulnerability of real-estate collateral set the collateral impairment and thus the share that cannot be recovered in default. The third is the debt service coverage ratio: in project finance, revenue and operating-cost sensitivity changes the project’s capacity to service its debt. The output of the three channels flows into expected credit loss (PD × LGD × EAD) and from there into IFRS 9 provisions, risk-weighted assets and the internal capital adequacy assessment. The Turkish banking regulator’s guidance describes this chain as “transmission channels”: physical and transition risk factors affecting the bank’s financial position through the borrower’s capacity to pay, asset and collateral valuations or macroeconomic factors. How it is measured at portfolio level is described on the UrClimate Next page; the capital consequences are discussed in our article on physical climate risk for banks.
Insurance and reinsurance: risk selection, pricing, accumulation
For an insurer, financial quantification shows up in three decisions. In risk selection (underwriting), a location-based hazard score supports the accept-and-terms decision at quote time. In pricing, average annual loss is the climate component of the pure premium. In accumulation, the part of the portfolio that would be hit by the same event is measured with probable maximum loss; reinsurance structuring and capital decisions rest on it. One frequent confusion needs separating: a hazard score on a 1-100 scale is a country-relative hazard index within the modelled geography; it is not a damage ratio and not a probability of loss. Scores compare and prioritize risks; AAL and PML price them and allocate capital. How the score and the financial layer are delivered together is shown on the UrClimate Score page.
The reporting and assurance link: IFRS S2, TSRS 2, the BDDK guidance, EBA
IFRS S2 and TSRS 2. The Türkiye Sustainability Reporting Standard TSRS 2 is the national adoption of the ISSB’s IFRS S2. In both, paragraphs 15 to 21 under “Financial position, financial performance and cash flows” require an entity to disclose the effects of climate-related risks and opportunities in the reporting period (current financial effects) and the anticipated effects over the short, medium and long term, with quantitative and qualitative information. When giving quantitative information the entity may disclose a single amount or a range; it uses all reasonable and supportable information available at the reporting date without undue cost or effort and applies an approach commensurate with its skills, capabilities and resources. Quantitative information is not required when the effects are not separately identifiable or when the measurement uncertainty is so high that the quantitative information would not be useful; the entity then explains why and identifies the line items likely to be affected. On 18 August 2025 the IFRS Foundation published educational material on disclosing anticipated financial effects applying ISSB Standards. In practice this makes financial quantification the output the standard expects rather than an optional extra; the relief route requires justification. How TSRS, IFRS S2 and the CSRD treat physical risk is compared in our comparison article.
The BDDK guidance. The Turkish banking regulator’s Guidance on the Management of Climate-Related Financial Risks, dated 13 March 2025, entered into force on 1 July 2025. Its capital and liquidity adequacy principle asks banks to identify and quantify climate-related financial risks and to include the material ones, including stress tests where appropriate, in their internal capital and liquidity adequacy assessment processes; its scenario analysis principle asks for physical and transition risks to be assessed as drivers of credit, market, liquidity and operational risk. “Quantify” is the regulatory counterpart of portfolio-level financial quantification. The relevant dates are on our Türkiye climate regulation timeline.
EBA Pillar 3 ESG disclosures. The European Banking Authority published its final draft implementing technical standards updating the ESG risk disclosures under Article 449a of CRR3 (EBA/ITS/2026/02) on 22 June 2026 and submitted them to the European Commission; application dates depend on Commission adoption. For banks in Türkiye that supply data to their EU parent groups, the standard is the reference for which physical risk items are disclosed at group level.
Assurance. Sustainability reports prepared under TSRS are subject to assurance, starting with limited assurance. For a financially quantified figure to hold up in assurance, the source data, model version, scenario assumptions and validation steps must be traceable. How that trail is built is explained on our TSRS climate reporting page.
Use by sector
Banks
Each asset in the credit portfolio is matched to a location and a sector code; the hazard profile is translated through three channels into expected credit loss and capital impact; the outputs are arranged for the TSRS 2 report, the BDDK ICAAP annex and the EBA templates. Details: the banking sector page and UrClimate Next.
Insurers and reinsurers
Location score at quote time, accumulation visibility across the portfolio, average annual loss in pricing and probable maximum loss in reinsurance structuring. Insurance, reinsurance and pension companies are among the categories within TSRS scope; the same metrics serve the reporting side. Details: the insurance and reinsurance sector page and UrClimate Score.
Corporates and real estate
Asset-level hazard profiles for plants, warehouses, offices and retail sites; average annual loss, probable maximum loss, business interruption and adaptation investment; the financial-effects section of an IFRS S2 or TSRS 2 report and a portfolio summary for due diligence. For global portfolios, hazard scores are produced at coordinate level across 182 countries.
Energy producers
For wind, solar and hydro plants, climate risk becomes financial through lost generation, workability and asset damage. The Climate Risks module of UrClimate Tailor reports five hazards under scenarios as average annual loss and net present value; the methodology is aligned with NGFS, UNEP FI, IIGCC PCRAM 2.0 and IFRS S2/TSRS.
Data centres
In a data center, physical climate risk becomes financial mainly through the effect of heatwaves on cooling capacity and operating cost, of flood and lightning on continuity, and of outdoor flow conditions on intake temperature: downtime becomes lost service, cooling load becomes annual energy cost, and updated design conditions become capital expenditure. See our climate-resilient data center page, where design, operation and risk assessment are treated under one roof, and our data center CFD service.
Municipalities and provincial administrations
Local climate action plans and the SECAP framework call for a climate risk assessment that prioritizes exposure across a city’s critical infrastructure and budget; financial quantification here is the case for adaptation investment and the evidence for climate finance applications. Details: SECAP and city GHG inventories and UrClimate Kent.
The Alkazar approach: physics to finance under one roof
Physical climate risk work often stops at one end of the chain: a hazard map or a portfolio report. Alkazar joins the two ends on one data foundation: hazard comes from climate projections downscaled to asset scale; exposure and vulnerability come from the client’s own asset and portfolio data; the financial metric follows the industry’s standard definitions. Behind every number stand the source data, the scenario assumption and a timestamp; an auditor or a regulator can reproduce the same result.
UrClimate Score
For any address or coordinate in 182 countries, a country-relative 1-100 score per hazard; a flood depth and average annual loss layer; earthquake average annual loss, probable maximum loss and net loss as a separately licensed premium layer. Dashboard and API for insurers, banks and asset investors. Product page
UrClimate Next
For a bank’s credit portfolio: six physical hazards, three credit-risk channels (PD, LGD, DSCR), expected credit loss and capital impact; SSP2-4.5 and SSP5-8.5 scenarios on an annual 2015-2100 axis; deployed inside the bank’s own network, deterministic and audit-tracked. Product page
UrClimate Tailor
One platform for energy assets from hourly forecasts to 2100 climate scenarios; the Climate Risks module covers five hazards, scenarios, average annual loss and net present value, with a print-ready report. Product page
Consultancy and reporting support
Scoping and gap analysis, asset-level hazard exposure and scenario generation, financial quantification, report-ready outputs in TSRS 2 structure and assurance support. TSRS climate reporting
The backbone of the method: climate projections rest on the CMIP6 ensemble aligned with IPCC AR6; SSP2-4.5 serves as the baseline and SSP5-8.5 as the stress test, on an annual 2015-2100 axis; global model output is downscaled to asset scale; every hazard is normalized to a 0-1 range and compound hazard structures are built into the model; the flood score was checked against 45 real flood events whose locations were reported in public news, and every event location scored between 62 and 94 out of 100. Uncertainty is not hidden; it is reported explicitly by scenario and time horizon. Our scientific stance is set out on the Science and Methodology page. Methodology details and the validation chain belong to Alkazar.
Frequently asked questions
What is physical climate risk?
Physical climate risk is the potential damage that climate-related natural events can do to assets, operations and revenues. Hazards that strike in a single event, such as flood, storm, hail, lightning, wildfire, drought and heatwave, are acute; shifts that build up over time, such as sea-level rise, changing precipitation patterns, reduced water availability and rising average temperatures, are chronic physical risk. Its financial consequences appear as direct damage, business interruption, higher operating cost, adaptation investment and asset impairment.
What does quantifying physical climate risk in financial terms mean?
It means combining the hazard at a location, the exposure of the asset there and its vulnerability, and translating the result into currency: average annual loss, probable maximum loss, lost revenue, asset impairment, or the change in a loan’s probability of default and loss given default. The result is a number that can be used directly in a balance sheet, a credit file or a policy.
What is the difference between AAL and PML?
Average annual loss (AAL) is the mean expected loss per year over the long run and the basis of pricing. Probable maximum loss (PML) is the loss level expected at a given return period, for example once in 100 or 250 years, and the yardstick for accumulation and capital decisions. Both are derived from the same loss distribution: one reads the mean, the other the tail.
How does climate risk become credit risk?
Through three channels: the hazard sensitivity of the borrower’s sector changes probability of default, the location and vulnerability of the collateral changes loss given default, and the revenue and operating-cost sensitivity of a project changes the debt service coverage ratio. The output of the three channels flows into expected credit loss (PD × LGD × EAD), IFRS 9 provisions and the internal capital adequacy assessment.
Do IFRS S2 and TSRS 2 require financial effects to be disclosed in numbers?
Paragraphs 15 to 21 of IFRS S2 and of TSRS 2 require the current and anticipated financial effects of climate-related risks and opportunities to be disclosed with quantitative and qualitative information; quantitative information may be given as a single amount or a range. Quantitative information is not required when the effects are not separately identifiable or when the measurement uncertainty is so high that it would not be useful; the entity then explains why.
What does the BDDK guidance ask of banks?
The guidance dated 13 March 2025 and in force since 1 July 2025 asks banks to identify and quantify climate-related financial risks and to include the material ones, including stress tests where appropriate, in their internal capital and liquidity adequacy assessment processes, and to assess physical and transition risks through scenario analysis as drivers of credit, market, liquidity and operational risk.
Is a risk score the same as a financial loss?
No. A hazard score on a 1-100 scale is a country-relative hazard index within the modelled geography; it is not a damage ratio and not a probability of loss. Scores are used to compare and prioritize locations; financial metrics such as average annual loss and probable maximum loss are calculated once exposure and vulnerability are added.
What data is needed to start?
The location of the asset or collateral (latitude and longitude), asset type and value, for banks the borrower’s sector code (NACE) and loan parameters, for companies the revenue and operating-cost structure. Hazard data and vulnerability relationships are supplied by Alkazar; the client’s data does not have to leave the organization.
Let us turn the climate risk of your assets or portfolio into a number
We can start with a list of facilities, a credit portfolio or a set of policies; in a first call we define the scope, the data needed and the output format together.
Contact us Science and MethodologyRegulatory information on this page is current as of October 2026 (IFRS S2 and TSRS 2 paragraphs 15 to 21; IFRS Foundation educational material of 18 August 2025; BDDK guidance of 13 March 2025, in force 1 July 2025; EBA/ITS/2026/02 of 22 June 2026). See the Türkiye climate regulation timeline for current dates.
Related pages
- Science and Methodology: data foundation, scenarios, validation and uncertainty
- UrClimate Score: location-based hazard scores and the AAL/PML layer
- UrClimate Next: PD, LGD, DSCR and expected credit loss for banks
- UrClimate Tailor: weather and climate risk for energy assets
- TSRS climate reporting in Türkiye: scope, requirements, process
- Physical climate risk under IFRS S2, ISSB and TSRS: comparison article
- Physical climate risk for banks: the capital effect
- Türkiye climate regulation timeline: dates and official sources
- Banking and insurance and reinsurance sector pages
- Climate-resilient data center: design and risk assessment