Physical Climate Risks

Physical climate risks refer to the economic and financial risks arising from the direct physical impacts of climate change. These risks have become increasingly significant for banking, finance, and the Indian economy due to India’s high exposure to climate variability, extreme weather events, and long-term environmental changes. Physical climate risks affect economic activity, asset values, income stability, and financial soundness, making them a critical concern for financial institutions and policymakers.

Concept and Nature of Physical Climate Risks

Physical climate risks arise from climate-related hazards that cause damage to physical assets, disrupt economic processes, and reduce productivity. These risks are commonly classified into acute and chronic physical risks. Acute risks result from extreme weather events such as floods, cyclones, heatwaves, and droughts, while chronic risks emerge from gradual environmental changes including rising temperatures, sea-level rise, desertification, and changing rainfall patterns.
In the financial context, physical climate risks translate into credit risk, market risk, operational risk, and liquidity risk. Banks and financial institutions face losses when borrowers’ repayment capacity weakens due to climate-related disruptions or when the value of collateral assets declines.

India’s Vulnerability to Physical Climate Risks

India is among the most climate-vulnerable economies due to its geographic diversity, demographic pressures, and economic structure. A large share of the population depends on climate-sensitive sectors such as agriculture, fisheries, and informal services. The monsoon plays a central role in agricultural output and rural incomes, making the economy particularly sensitive to rainfall variability.
Coastal regions face rising risks from cyclones and sea-level rise, threatening ports, industrial clusters, housing, and tourism. Inland regions are increasingly exposed to heat stress, water scarcity, and flooding. These vulnerabilities increase the likelihood that physical climate shocks will affect multiple sectors and regions simultaneously, amplifying systemic risk.

Impact on the Banking Sector

Physical climate risks directly affect the banking sector by impairing asset quality and increasing default risk. Agricultural lending is highly exposed to droughts, floods, and irregular rainfall, which reduce farm productivity and incomes. Micro, small, and medium enterprises are similarly vulnerable, as they often lack adequate savings, insurance coverage, and adaptive capacity.
Damage to housing, infrastructure, and commercial property reduces the value of collateral backing bank loans, increasing credit losses. Repeated climate-related shocks can result in a persistent rise in non-performing assets, placing pressure on profitability and capital adequacy. Operational risks also increase when extreme weather events disrupt branch operations, payment systems, and digital infrastructure.
The Reserve Bank of India has recognised that physical climate risks can pose systemic threats to financial stability, particularly when multiple regions and sectors are affected simultaneously.

Effects on Financial Institutions and Markets

Beyond banks, physical climate risks affect insurance companies, non-banking financial companies, pension funds, and capital markets. Insurers face higher and more volatile claims from floods, cyclones, and heat-related losses, challenging traditional risk pricing and solvency management.
Financial markets may experience increased volatility following major climate events, especially in sectors such as real estate, infrastructure, agriculture, and utilities. Long-term investors face valuation risks where assets are located in climate-vulnerable regions or depend on climate-sensitive cash flows.

Macroeconomic Implications for the Indian Economy

At the macroeconomic level, physical climate risks can slow economic growth by disrupting production, damaging capital stock, and reducing labour productivity. Increased public spending on disaster relief, rehabilitation, and climate adaptation places additional pressure on fiscal balances.
Climate-related supply disruptions can contribute to inflationary pressures, complicating monetary policy transmission. Regional inequalities may widen, as poorer and climate-vulnerable areas are often more severely affected, reinforcing economic and financial stress.
International institutions such as the International Monetary Fund have emphasised that unmanaged physical climate risks can undermine macroeconomic stability and long-term development in emerging economies like India.

Risk Management and Policy Response

Effective management of physical climate risks requires their integration into financial decision-making and regulatory frameworks. Banks are increasingly expected to incorporate climate risk assessments into credit appraisal, portfolio monitoring, and stress testing. Improved climate data, risk modelling, and disclosure are essential for accurate risk pricing.
Public policies promoting climate-resilient infrastructure, agricultural adaptation, and disaster risk financing play a crucial role in reducing long-term economic losses. Expanding insurance coverage and strengthening risk-sharing mechanisms can further enhance financial and economic resilience.