The impact of climate change-induced physical risk has worsened in intensity and frequency since the World Economic Forum’s Global Risks Report was launched in 2006. Extreme weather events are anticipated to become even more of a concern than they already are, with this risk being top-ranked in the 10-year risk list for the second year running in the WEF’s latest report.
In the first month of 2025, the most obvious example of the increasing threat posed by extreme weather has been seen in the US. With the country still reeling from the Los Angeles wildfires – one of the costliest wildfire disasters in modern US history, according to AccuWeather chief meteorologist, Jonathan Porter – Gulf Coast states were battered with what was described as a ‘historic’ winter storm that threatened major power outages from Texas to Florida.
Institutional investors, including insurers, pension funds and mutual funds, are exposed to physical risk through business disruption, which can severely impact the value of their assets. But, while the need to manage transition risks by supporting companies to reduce their greenhouse gas emissions – known as mitigation – is a core engagement and investment strategy for sustainable fund houses, helping them to adapt to the impacts of physical climate change is less well understood, and even less well funded. The UN Environment Programme’s 2024 Adaptation Gap Report, for example, estimated the funding gap for adaptation to be as high as $359bn per year.
Adaptation investment lenses
In explaining adaptation, Anya Solovieva, director of global commercial product strategy for climate solutions at Sustainalytics, said from an investor perspective there are two lenses for consideration. The first concerns the adaptation activities a company takes to adapt its operations in response to the impact of physical climate change, such as a utility company that deploys its power lines underground rather than utilise overhead cabling.
While physical risk may not materialise as a financial risk if investee corporations are already taking action to address it, equity investors should be cautious, as some companies may not be taking measures now or do not have plans to mitigate physical risks, according to the Climate Policy Initiative. Such risks, they continue, are particularly problematic for companies where location determines the value of assets. For example, the value of properties or ports relies on the suitability of the location – physical risks such as flood, storm, cyclone, water stress and sea level rise can erode the value of these assets.
Solovieva explained, in 2024, she started to get asked more questions about adaptation from fund managers. “Partly because of the Taskforce for Climate-related Financial Disclosure reporting initiatives, investors are conducting initial screenings of their portfolios on their exposure to the physical impacts of climate change. But most of the questions I was asked were about evaluating and comparing companies on their risk exposure. Let’s say two companies were threatened by increasing exposure to wildfires. If one was taking steps to adapt, and the other wasn’t, then that has very different implications in terms of potential future cash outflows.”
The second lens, continued Solovieva, is about investment opportunity: finding companies that provide products and services that help to facilitate adaptation. This could be anything from companies providing water desalination services, to innovative air conditioning technology that can manage extreme heat in factories, to concrete for flood barriers.
‘The need is now’
This second lens is something that Redwheel is actively researching and investing in. Portfolio manager Amanda O’Toole and Stephanie Kelly, who leads Redwheel’s thematic sustainability research division, Greenwheel, told it’s essential for financial institutions to start having more genuine conversations about what it looks like to invest in adaptation solutions because “the need is now”.
Nicole Lim, ESG investment manager in fixed income at abrdn, agreed, saying adaptation “is an area where many investors are still catching up”, especially regarding identifying opportunities that meaningfully build resilience against physical climate risks.
“A common misconception is the exclusion of adaptation within transition-focused investing. A just transition should encompass both mitigating climate risks, as well as adapting to them,” Lim asserted.
Kelly also highlighted this problem, explaining adaptation “has got a bad rap” because it’s associated with giving up on mitigation and being resigned to letting climate change happen unabated – something she describes as a fundamental mistake.
“Partly it comes from a lack of understanding that, even in the best-case scenario of 1.5°C of global warming, which is where we are now, you still have such an enormous amount of adaptation required,” continued Kelly.
“People have felt they had to put everything into mitigation – which is extremely important, I don’t want to downplay that at all – but when Amanda and I conducted our initial research on building a theory of change, we discovered there are adaptation solutions that are mitigation friendly, and there are adaptation solutions that aren’t quite so mitigation friendly, and that is tough to acknowledge, because, in some areas, there’s this view of a trade-off. So, for example, air conditioning is quite energy intensive, but it is an adaptation, so I think that’s also part of the challenge for investors who care about climate.”
O’Toole agreed, saying it requires a shift in mindset from an investor’s perspective when constructing a portfolio universe. “I think anybody running an adaptation solutions fund would also want to make sure they’re not putting themselves in a position where they are investing in companies that are to the detriment of climate mitigation efforts. Some adaptation solutions won’t fit within a conventional sustainable investment universe, but, equally, there’s still a huge need for solutions to protect from fire or coastal flooding, for example, which makes it a difficult conversation to start.”
With images of the LA wildfires broadcast widely and bringing the threat of extreme weather events closer to home, however, these conversations are beginning in earnest, added Kelly.
“Until now, the effects of climate change were seen as a thing happening in emerging markets, and it was the role of Western nations to just reduce their reliance on fossil fuels. But once people are affected by that risk themselves, they’re much more incentivised to do something about it. The LA fires have highlighted this isn’t just a problem for poor countries, it’s a problem for everyone.”
Defining the solutions universe
To construct an investment universe for adaptation solutions, Kelly and O’Toole began by asking what the options were for a company when it comes to adapting to physical climate risk. From there, they identified three different types of companies: those not at risk from climate change or are already well adapted, such as a vertical farm; those that require new solutions to adapt to physical risks to continue operating in the same way; and those that must adapt the way they operate to account for physical risks.
Of those three options, the opportunity for new solutions was deemed to be the most interesting from an investment perspective. The Greenwheel team mapped out the materiality of such investments and considered changes that could be made to improve things and create additionality.
“From an investment standpoint, we want to invest behind the solutions providers because we think there’s a significant opportunity in businesses that can meaningfully contribute and help us to adapt, over many decades into the future, and there is very much a propensity to buy those solutions where they’re available. So, we want to be able to offer clients exposure to those solutions providers,” asserted O’Toole.
Such solutions are not only the preserve of the tech sector. O’Toole suggested good adaptation solutions pull together leading-edge technology, sophisticated physical infrastructure and natural capital solutions in a holistic manner, further broadening the investment opportunity.
She cited Arcadis – a Dutch design and consultancy organisation for natural and built assets – as a good example. “They’ve been involved in the planning for the water system in the city of Makkah in Saudi Arabia, better flood defences for storm surges in lower Manhattan, and flood protection around the river Aire in Yorkshire, which I can tell you personally has been something of a success story. So, for me, this is a great example of a business that can contribute towards much more sophisticated, holistic thinking to address some of these big challenges.”
Growing demand for products and services
Evidence of increased spending and interest in adaptation has also been noted by Seb Beloe, partner and head of research at WHEB Asset Management. In an online article, Beloe explained holdings in the group’s Climate Adaptation thematic strategy – including Arcadis and Advanced Drainage Systems – had reported increasing demand for their products and services in recent earnings calls, as clients look to adapt to increases in extreme weather.
“Other companies held in the strategy are also seeing growing demand for products and services that help make communities more resilient in the face of a changed climate,” he continued. “This includes demand for efficient cooling systems from Trane Technologies, water treatment and management equipment from Xylem and even fire-fighting equipment from MSA Safety. Most of MSA’s fire-fighting equipment is used in fighting fires in buildings. The company does also supply kit for fighting fires in rural areas – including to firefighters working to extinguish the Palisades and Eaton fires.”
Despite the increasing recognition of the investment opportunities, however, options are still limited, with many companies in this space in the private market. Solovieva explained that, according to Sustainalytics’ impact metrics data set, just 541 publicly listed companies derive revenues from at least one of the 12 adaptation-related sustainable activities, from around 12,500 companies in the sample.
For Lim, the lack of investment opportunities makes it challenging for investors. “From our experience managing climate transition-focused investments, identifying good adaptation investments requires an understanding of how localised resilience intersects with investable opportunities. This also needs to be supported by a robust guiding framework for allocation to facilitate the inclusion of such assets into portfolios.”
But O’Toole added the investment universe for adaptation solutions will continue to expand and progress over time, having seen similar progress in other areas of sustainable investing.
“We could talk about the opportunities in the food supply chain, managing extreme weather through environmental engineering, disaster response, building resilient infrastructure, protecting our increasingly electrified and connected economy from cyberattacks, etc. There’s a lot that needs to be done, and that’s without even thinking about the financial innovation that’s bound to come to support the funding and insurance of these new areas because this is a landscape that’s changing very significantly for those financial players. It’s an unquestionably broad set of challenges and opportunities.”
Less political baggage
Sustainable fund houses concerned about the politicisation of sustainability and ESG may also find adaptation doesn’t carry the same baggage as mitigation.
“The fundamental shift of the kind we’re trying to enable is really hard; extremely important, but really difficult. And, over the last couple of years, this technical and complex thing has become rightly or wrongly associated with a moralistic or ethical conversation,” explained Kelly.
“Compared to mitigation, adaptation doesn’t represent a challenge to how people go about their lives, we’re not talking about something so personally transformative. If anything, we’re talking about things people can do so they can continue to live their lives as they currently do, and that is a much easier conversation to have.”
O’Toole offered a different perspective: “For me, one of the reasons this is an easier investment decision for a corporation or a government to support is because it’s much easier to measure the payback for investments in adaptation. Mitigation is a positive thing long-term, but it’s difficult to quantify over that kind of investment horizon, whereas it’s easier to quantify the economic and human benefit of preventing a flood in an area of valuable infrastructure and assets, or where there are a number of people living. This makes the payback easier to calculate because it’s less discretionary.
“I am not for a second suggesting that climate mitigation investment ought to be discretionary, and I don’t feel that it is. But the benefits are harder to measure because it’s such a long-term investment and the propensity is to defer that investment when there are other, more urgent investments in the shorter term. And I don’t think that’s the case for adaptation.”
Given what seems like a more hostile environment for sustainable fund managers in the wake of Donald Trump’s return to power in the US, perhaps the less discretionary payback for adaptation investments could see more fund managers pivot their strategies accordingly.
