An asset-level analysis of financial tail risks under extreme weather events

Extreme weather events pose a risk to the economic and financial system. To understand the materiality of these risks, financial institutions are beginning to conduct climate stress testing exercises. This requires climate risk models to be integrated with financial risk models. In this paper, we introduce an open, modular, and reproducible framework for the assessment of asset-level physical risk and the translation of these risks into portfolio-level impacts. The proposed framework addresses key limitations of previous research by including multiple financial transmission channels, and the incorporation of spatial correlations between weather events for bottom-up, asset-level, estimation of portfolio-level tail risks. By incorporating direct capital damages, business disruptions, and insurance coverage, we provide an overview of the direct financial impact of extreme weather events. Through an application of the framework for the assessment of flood risk to a portfolio of power firms located in India, we show that these extensions have material impacts on the risk estimates. We further show how different assumptions related to spatial correlations can lead to large under- or overestimations of portfolio-level tail risks.