Four mistakes firms make when conducting physical risk scenario analysis…and how to avoid them

Climate risks are mounting, from fires in Los Angeles to record-breaking heatwaves across Europe. Last year alone, climate-related losses exceeded $320 billion. Given the increasing risks, firms need to measure and manage how climate impacts will affect their assets and operations more than ever.

As I work with organizations around the world to build their capacity and help them conduct risk analysis I have seen 4 common errors in scenario analysis for physical risk assessments. These errors limit the value and impact of scenario analysis and leave firms unprepared in the face of rising climate risks.

Through our team’s extensive work on climate scenario analysis and my background in financial stress testing and risk modeling, we’ve identified 4 key mistakes to avoid and a series of strategies for addressing them.

This piece explores those errors and their solutions and offers a practical toolkit for reviewing and overcoming these challenges.

Mistake 1: Confusing Average Scenarios with Extremes 

One common and costly error firms make when assessing physical climate risk scenarios is conflating an average with extreme or worst-case conditions. Often, organizations select a high-warming scenario, for instance, representative concentration pathway (RCP) 8.5, and assume it inherently captures the worst-case risks they might face. While this approach is intuitive, it can lead to significant underestimations. 

Why? Because temperature increases alone do not fully define risk. Climate impacts depend on multiple interacting factors. Consider two worlds both warmed by two degrees Celsius: in one, effective adaptation measures limit damage; in the other, the same two-degree rise triggers devastating impacts due to poor preparation and unexpected tipping points, such as accelerated sea-level rise or sudden shifts in weather patterns. 

Focusing only on average conditions also ignores the critical importance of extreme events, the so-called tail risks. It is very different assessing risks under the average conditions in a high warming scenario versus more extreme ones (>95th percentile).  Such analysis may overlook potentially catastrophic outcomes that could profoundly affect operations. For example, analysis might indicate floods become twice as frequent in a two-degree scenario. But what if, instead of doubling, floods increase tenfold in your specific geographic region? Relying on the average of a pathway misses this crucial dimension, leaving your business exposed and unprepared. 

From a strategic standpoint, effective risk assessments are always about the extremes rather than the averages. No financial supervisor would set capital requirements based on average market losses but would insist on looking at losses under the Global Finance Crisis or other market turmoil. Likewise, climate risk managers should not rely solely on mean projections. Tail risks, those unlikely but high-impact scenarios, must be actively explored and prepared for. 

To avoid this mistake, firms should deliberately incorporate analysis that stress-tests their resilience against worst-case or extreme outcomes. That means actively seeking out and understanding the full range of risks, not just the midpoint of a given climate projection. By doing so, companies gain a clearer picture of their true vulnerabilities and are better positioned to build robust, flexible strategies that withstand climate shocks. 

Mistake 2: Misalignment of Time Horizons 

A second major error many firms make when evaluating physical climate risks is using inappropriate time horizons. This is a persistent challenge because many physical climate models are focused on small average shifts that add up to big effects only after decades. Although global temperatures are rising at a rapid pace in geological terms, year-to-year differences may remain modest as model inputs. As a result, there is a persistent misconception that climate is a future problem and risk assessments only need to consider the second half of the 21st century.  

This approach leads to two significant problems. First, financial models heavily discount to these “distant” risks. They reason that even enormous future losses appear modest when discounted back several decades. While this might make sense on a spreadsheet, it underestimates the current state of climate risks. Discounting future losses also creates a dangerous illusion of control and minimizes the urgency required to act now. 

The second problem with overly distant horizons is related directly to volatility and extremes discussed before. When firms set their analytical horizons far into the future, they often ignore the increasing unpredictability and severity of events that could today. For example, the hurricane season that a model indicates might occur more frequently in 50 years could realistically happen this year or next. Climate change is constantly increasing volatility, meaning that these tail events are becoming ever more common. 

Firms need to understand that the most dangerous climate risks are those occurring in the near term. Relying too heavily on average conditions and gradual changes gives a false sense of security. The reality is that these risks are immediate and rapidly escalating.  

Climate risk analysis should spend more time considering the disruptions from extreme events today rather than projections well outside business planning horizons. Organizations should shift their focus towards shorter, actionable timelines that capture both volatility and near-term risks. They should recalibrate their scenario analysis and decision-making processes to explicitly account for potential shocks that may appear suddenly rather than gradually. These changes will enable firms to be better positioned to respond effectively, minimizing disruptions and protecting their strategic interests today. 

Mistake 3: Narrowing the Range of Relevant Hazards 

A third frequent mistake organizations make when assessing physical climate risk scenarios is an overly narrow focus on limited set of hazards. Very often, firms approach their analysis by concentrating exclusively on a specific or even singular threat. Floods are perhaps the most common, and then assuming insurance will cover the others. This approach not only makes unrealistic assumptions about the insurance markets but ignores that climate change is a systemic issue with far-reaching impacts. 

For instance, an agricultural company evaluating climate risk might initially focus on drought and heat stress, as these are clearly connected to crop health. But this narrow lens misses broader risks, such as overall yield reductions resulting from shifting growing seasons, changes in rainfall patterns, and increased vulnerability to pests and diseases. The cumulative impact on production might be far greater than what a simple heat-focused analysis might suggest. 

Similarly, when it comes to public health, organizations may focus primarily on illnesses directly associated with heatwaves, overlooking other critical health impacts. Climate change is also altering the distribution of disease vectors such as mosquitoes, ticks, and other pests, significantly increasing the risks of vector-borne diseases. Additionally, shifting weather patterns can indirectly impact public health by influencing water quality, air pollution, and food availability. Each of these hazards requires thoughtful consideration to accurately assess overall health implications. 

Even flooding, a common focus of many scenario analyses, is too often assessed on one dimension such as coastal storm surges. As climate change intensifies rainfall events, inland river flooding and flash flooding become increasingly significant concerns. Assets in cities previously considered safe from flooding might now find themselves vulnerable due to overwhelmed drainage systems and infrastructure that was not built to handle higher volumes of rainfall. 

Ultimately, climate change exerts influence on a wide variety of physical phenomena. By narrowing the scope of analysis, firms overlook many critical climate-driven risks that can compound or amplify each other. Firms need a comprehensive approach to scenario analysis, one that considers a wide and interconnected range of climate-related hazards. A broader assessment ensures a clearer, more accurate understanding of vulnerabilities. 

Mistake 4: Ignoring Second-Order Effects  

The fourth common mistake firms make when analyzing short-term physical climate risks is overlooking second-order effects and broader systemic correlations. Too often, scenario analyses is conducted as a standalone exercise and one focused only on the direct financial effects of climate impacts. 

Too often, businesses frequently underestimate indirect consequences, such as prolonged business interruptions following an extreme weather event. A severe storm will do more than damage physical infrastructure; it disrupts supply chains, halts operations, and leads to lost revenues, potentially long after the initial event.  

Consider credit risk. The effect of climate impacts on a company’s credit quality derives from much more than the direct financial losses from an event. For instance, a flood’s disruptions may result in reduced revenues and also require spending to boost resiliency in the future. Furthermore, in many cases insurance may not cover some of the second-order effects of the flood. Each of these consequences can impact credit quality. Climate-related disruptions can also reduce consumer demand, increase operational costs, and negatively influence investor perceptions, all factors that may result in larger losses than an estimate of direct losses would yield.  

Furthermore, climate impacts may ultimately trigger shifts in insurance markets and regulatory policies. If insurers withdraw coverage from high-risk areas, companies may find assets rapidly losing value or becoming stranded. 

Firms must avoid viewing climate risks in isolation. A comprehensive scenario analysis should explicitly incorporate second-order effects and broader economic and regulatory interdependencies. By capturing these relationships, organizations gain a more accurate, realistic picture of the risks they are facing.  

Conclusion 

This piece sought to highlight four common mistakes I see in physical risk scenario analysis that can undermine the usefulness of the work and leave organizations underprepared.  

Those mistakes include assessments that: 

• Focus on average conditions 

• Use overly long-time horizons 

• Consider only a narrow range of hazards  

• Fail to account for second-order effects  

Each of these can produce a distorted picture of the risks a firm face. 

We hope this analysis helps teams think more clearly and critically about how they approach climate risk and prepare for a changing world.

Enjoyed this analysis? D. A. Carlin & Co helps clients navigate these turbulent times through strategic briefings, practical capacity-building workshops, and regulatory support. Book a call with us today through our "Speak with us" form and find out how we can give you and your team the future-ready skills and strategies you need.