Known unknowns of infrastructure investments

Hurricanes, storms, wildfires, and environmental hazards are becoming more common, leading to the destruction of infrastructure with severe consequences for society and economic activity.

As Figure 1 shows, the average surface temperature of the Earth is rising, which is likely to increase multi-billion-dollar weather events and climate disasters.

Figure 1: Earth’s average yearly surface temperature has risen to record levels

Source: Climate.gov (2024). Climate Change: Global Temperature. Link. Retrieved on January 20, 2025

Earth’s average yearly surface temperature from 1880 to 2023, compared to the 20th-century average (1901–2000). The grey bars indicate cooler-than-average years; the red bars show warmer-than-average years. NOAA Climate.gov graph, based on data from the National Centers for Environmental Information.

Moody’s Insurance Solutions estimated the combined total private market insured losses caused by hurricanes Helene and Milton, which hit Florida in October 2024, to be between USD 30 billion and USD 50 billion.¹ Such hazards impact power lines, causing power outages. Wildfires are also a prevalent cause of weather and climate hazards^2,3, affecting US utilities’ operations. Despite their rising occurrence, there is a significant gap between insured and uninsured losses from natural catastrophes. Based on 10-year total figures, Swiss Re puts the protection gap at 43% for North America, 70% for EMEA, and 85% for Asia.⁴ Similarly, Aon estimates the global protection gap between economic and insured losses at 69%.⁵ Without sufficient insurance protection, investors should consider physical risks when evaluating infrastructure investments.

Physical risks are often referred to as “known unknown” risks. The market is aware of them, but generally does not factor them into asset prices because the timing and significance of these events are unknown. For example, in 2017, Pacific Gas & Electric in California⁶ and Hawaiian Electric Industries in 2023⁷ faced significant financial impacts due to wildfires. The market did not price the physical nor the financial risks associated with these wildfires before their occurrence, which lead to material losses for investors.

The Intergovernmental Panel on Climate Change (IPCC) issued a seminal study on managing risks of climate-related extreme events and disasters in 2012.⁸ The IPPC risk framework defines physical exposure to climate hazards and vulnerability as risk determinants. Yet, not all investors have incorporated these risks into their assessments since then.

Physical risks vary across sectors and require identification prior to assessment. Verschuur et al. (2024)⁹ plotted combinations of vulnerability and impacts of climate hazards and infrastructure types across gradients of impact and vulnerability. While acknowledging the challenge of scaling up the analysis across geographies, the authors found that extreme wind is the largest risk for electricity distribution and transmission (T&D), extreme heat for airports, and extreme cold for railroads, toll roads, and telecommunication infrastructure (Figure 2).

Figure 2: Overview of operational thresholds for extreme wind, extreme heat, and extremely cold temperatures across infrastructure sectors

Sources: Verschuur J, Fernández-Pérez A, Mühlhofer E, Nirandjan S, Borgomeo E, Becher O, et al. (2024) Quantifying climate risks to infrastructure systems: A comparative review of developments across infrastructure sectors. PLOS Clim 3(4): e0000331. https://doi.org/10.1371/journal.pclm.0000331. Under Creative Commons Attribution License. CC BY 4.0. No modification undertaken.

Today, Geographic Information Systems (GIS) and geospatial data enable the identification of the potential impact of environmental hazards at a high level. Large financial data vendors have recently consolidated the sustainability data market, including services to assess physical risks. Although evaluating physical risks quantitatively from third-party data only provides initial insights, relying solely on third-party data could lead to inconsistent results, as evidenced by recent academic studies.¹⁰ Therefore, a deeper qualitative due diligence is required.

As part of our investment due diligence, we integrate physical risk into our stock selection process and do not rely solely on third-party data assessments. We also evaluate companies’ physical risk mitigation strategies. For example, for US electric utilities and wildfire risks, we follow Cody (2024),¹¹ which classifies utilities’ wildfire reduction strategies into three groups: (i) system hardening, such as safety power shutoffs that shut down grids prior to strong winds, (ii) vegetation management, that is removing vegetation in a corridor around power lines, and (iii) operational mitigations. The choice of companies’ risk mitigation strategies has financial implications, affecting asset valuation and the cost of debt.

Physical infrastructure risks are essentially negative externalities not efficiently valued by markets. Due diligence on physical risks is required to help avoid potential investment losses. This can be achieved by analyzing exposure and vulnerability to climate and weather hazards. The likelihood of the impact can be assessed with models based on geospatial data and enhanced by evaluating companies’ risk mitigation strategies. As the effects of climate change become increasing acute, assessing physical risks should form an integral part of a sound investment process to invest in infrastructure assets.

¹ Moody’s Insurance Solutions (October 2024), Moody’s RMS Event Response Estimates Private Market Insured Losses for Hurricane Milton to be between USD 22 Billion and US$36 Billion.
² New York Times (March 2024), Utility-Caused Wildfires Are becoming a National Problem.
³ National Interagency Fire Center (n.d.). Wildland Fire Summary and Statistics Annual Report 2023.
⁴ Swiss Re (March 2024), Understanding the growing impact of natural catastrophes to improve corporate resilience.
⁵ Aon (2024), Climate and Catastrophe Insight 2024.
⁶ Utility Dive (January 2019), PG&E files for 2nd bankruptcy, ignoring investor pleas. ; PBS News (April 2022), PG&E to pay USD 55 million for two massive California wildfires.
⁷ Honoulu Civil Beat (August 2024), Maui Judge Clears Path To Final USD 4.04 Billion Settlement Of Wildfire Cases.
⁸ IPCC– Field, C.B., V. Barros, T.F. Stocker, D. Qin, D.J. Dokken, K.L. Ebi, M.D. Mastrandrea, K.J. Mach, G.-K. Plattner, S.K. Allen, M. Tignor, and P.M. Midgley (Eds.) (2012), Managing the Risks of Extreme Events and Disasters to Advance Climate Change Adaptation. Chapter 2.
⁹ Verschuur J, Fernández-Pérez A, Mühlhofer E, Nirandjan S, Borgomeo E, Becher O, et al. (2024) Quantifying climate risks to infrastructure systems: A comparative review of developments across infrastructure sectors. PLOS Clim 3(4): e0000331. https://doi.org/10.1371/journal.pclm.0000331. Under Creative Commons Attribution License. CC BY 4.0. No modification undertaken.
¹⁰ Linda I. Hain, Julian F. Kölbel and Markus Leippold (2022), Finance Research Letters 46. Let’s get physical: Comparing metrics of physical climate risk.
¹¹ Cody (2024), Adapting to Wildfire Risk in the California Electric Power Sector.