Physical risk refers to the financial impact of both sudden events like hurricanes or wildfires and slower, long-term changes like rising sea levels. These risks can affect economic output by damaging infrastructure, disrupting supply chains, and lowering productivity. This slowdown in economic expansion can, in turn, lead to lower corporate earnings, and consequently, lower asset prices. For investors, understanding these risks, among a broad range of others, is not only a way to mitigate potential losses, it’s also a way to gain a competitive edge. Climate Scenario Risk Modelling Pricing physical risk is one of the toughest challenges confronting investors. Unlike financial risks, climate impacts follow complex, non-linear pathways (some sudden, others gradual) and lack clear market-based gauges. In lieu of precise measures, investors often rely on climate scenario analysis, which tests portfolio resilience under a range of “what if” futures. An internally developed damage function tool is among the resources CPP Investments and other global asset allocators use to support this type of scenario analysis at a country level in portfolio design. The damage function is not a forecasting tool or a determinant of specific investment decisions. Rather, it provides a way of translating potential physical climate impacts resulting from average temperature changes into comparable economic terms across regions. This allows CPP Investments to stress test assumptions, highlight vulnerabilities and understand how climate risks might interact with other drivers of long-term growth. While powerful in capturing long-horizon, non-linear climate effects across geographies, the damage function doesn’t operate as a market signal. Indeed, unlike short-term indicators that guide trading or allocation, the tool focuses on systemic, structural risks that play out over decades. Its value lies in informing long-term portfolio construction rather than influencing near-term market moves. In this sense, it works as a strategic input, one that, when aligned with CPP Investments’ guiderails on feasibility, cost-effectiveness, decision utility, and the expectation that it will enhance risk-adjusted returns, can shape how we evolve portfolio construction in a climate-challenged world. The damage function is only one part of a broader, multi-layered toolkit. Physical risk is also assessed at the security selection level, where analysis incorporates asset-specific exposures, resilience factors, and the potential financial impacts of climate risks on individual holdings. This ensures that conclusions drawn at the country level are supplemented by more granular, bottom-up analysis. How it Works First developed several years ago and still evolving, CPP Investments’ damage function estimates how rising temperatures affect GDP per capita growth in different countries under varying climate scenarios. It can be used to translate temperature changes into measurable financial terms, to compare risks across regions and countries, and ultimately, to evaluate the impact of climate-related vulnerabilities on portfolio resilience. The function does this by: Mapping temperature changes to economic indicators such as GDP per capita growth. Capturing the overall effect of temperature shifts through channels like agriculture, health, labour productivity and political stability. Incorporating lagged effects and short-term adaptation responses. Controlling for other factors such as geography, economic structure and global conditions using a fixed-effects statistical model. Determining the shape of the function through a fully data-driven approach. What the Damage Function Shows The effect of temperature increases is non-linear: that is, every additional degree of warming creates disproportionately greater economic damage. Warmer countries are especially vulnerable to future damage and deceleration in economic growth, which slows more sharply as temperatures rise. Cooler countries may see slight initial benefits from warming. But as temperatures continue to climb, negative effects become more pronounced, causing potential changes in agricultural yields, increased health risks, and greater political instability. Next Steps in Evolving the Tool CPP Investments is continually seeking to enhance the robustness and decision-usefulness of this tool, ensuring it evolves in step with new data, methodologies, and market insights. Looking ahead, both the tools and the broader framework to model physical risk impacts will need to advance to help drive actionable outcomes. Future enhancements will aim to capture: How adaptation and resilience efforts can offset damages. Ongoing changes in temperature extremes (rather than just average warming) in both cold and hot countries. Sector and asset specific vulnerability to physical risk hazards. The rising frequency and severity of extreme weather events compared to historical data. The potential for markets to re-price risk earlier than expected. Author Jamy Kallikaden Managing Director, Sustainable Design, Total Fund Management Kallikaden works with CPP Investments' Portfolio Design and Construction team. Contributors Maria Montero, Managing Director, Sustainability Strategy David Stewart, Managing Director, Sustainability Strategy How Octopus Energy is Revolutionizing Renewables and Reshaping Utilities In just nine years, British renewables company Octopus Energy has become the United Kingdom’s largest energy supplier. Article June 26, 2025 Physical Risk, Climate Change, and the Investor Response Johan Rockström is one of the world’s most prominent climate scientists. Video March 3, 2025 Why collaboration is key to achieving the energy transition and meeting global The energy transition is a defining test of our time—one that no single government, investor, or company can meet alone. Article December 17, 2024