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Earth sciences

What Is Climate Risk?

Climate risk refers to the potential negative impacts on financial assets, liabilities, and economic stability stemming from climate change. It encompasses both the physical risks associated with a changing climate, such as extreme weather events, and transition risks arising from the shift towards a lower-carbon economy, including policy changes, technological advancements, and market shifts. Within the broader field of Risk Management and Sustainable Finance, understanding and quantifying climate risk is becoming a critical component of sound financial decision-making for Financial Institutions, corporations, and investors. This evolving category of risk directly influences Valuation and can significantly affect the long-term performance of various asset classes.

History and Origin

The concept of climate risk as a significant financial concern gained prominence with increasing scientific consensus on climate change and its potential economic ramifications. While environmental concerns have long been a part of corporate social responsibility discussions, the explicit framing of climate change as a direct financial risk began to crystallize in the mid-2010s. A pivotal moment was the 2015 Paris Agreement, which spurred global recognition of the need for coordinated action on climate change, bringing its financial implications into sharper focus16.

Following this, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, established the Task Force on Climate-related Financial Disclosures (TCFD) in December 2015. The TCFD was mandated to develop a set of voluntary, consistent disclosure recommendations to help financial market participants understand their climate-related risks14, 15. These recommendations, published in 2017, provided a globally recognized framework for organizations to disclose their climate-related risks, opportunities, and financial impacts, thereby integrating climate considerations into mainstream Financial Reporting12, 13. Regulators worldwide have increasingly acknowledged the need for better disclosure, with the U.S. Securities and Exchange Commission (SEC) adopting final rules in March 2024 to require certain climate-related disclosures from publicly-traded U.S. companies in annual reports and registration statements10, 11.

Key Takeaways

  • Climate risk encompasses physical risks from extreme weather and climate patterns, and transition risks from the shift to a low-carbon economy.
  • It impacts financial assets, liabilities, and the broader economy, requiring integration into corporate and investment strategy.
  • International bodies like the TCFD and regulators such as the SEC have developed frameworks and rules for climate-related financial disclosures.
  • Managing climate risk is crucial for Financial Stability and long-term investment resilience.
  • Accurate Disclosure Requirements are essential for investors to assess a company's exposure to climate-related challenges and opportunities.

Interpreting the Climate Risk

Interpreting climate risk involves assessing how various climate-related factors can affect an entity's financial performance, strategic outlook, and operational continuity. This interpretation often starts with identifying both physical risks, such as damages from floods or wildfires, and transition risks, including changes in Regulatory Compliance, shifts in consumer preferences, or disruptions to Supply Chain due to climate policies.

For instance, a company with extensive physical assets in coastal areas faces direct physical climate risk from rising sea levels or increased storm intensity. Conversely, an energy company heavily reliant on fossil fuels faces significant transition risk as policies favor renewable energy or carbon pricing mechanisms are implemented. Effective interpretation requires a forward-looking perspective, often utilizing scenario analysis to evaluate the resilience of business models under different climate pathways. This helps in understanding potential financial impacts and informs strategic adjustments, influencing Investment Strategy and resource allocation.

Hypothetical Example

Consider "GreenGrowth Corp," a hypothetical real estate developer specializing in properties along coastlines. GreenGrowth Corp's Portfolio Management team conducts a climate risk assessment for a new residential development planned in a low-lying coastal area.

Step 1: Identify Physical Risks. The team identifies that the region is prone to hurricanes and has projected sea-level rise scenarios for the next 30 years.
Step 2: Quantify Potential Impacts. They estimate that a Category 4 hurricane, becoming more frequent under future climate scenarios, could cause $50 million in property damage and necessitate a $10 million increase in insurance premiums annually. Rising sea levels could eventually render parts of the development uninhabitable or require costly protective infrastructure.
Step 3: Assess Transition Risks. Simultaneously, new building codes and increased demand for Green Bonds to fund sustainable infrastructure could increase their financing costs or alter project feasibility.
Step 4: Formulate Mitigation Strategies. To address these climate risks, GreenGrowth Corp decides to:
* Elevate new constructions beyond projected flood plains.
* Invest in resilient building materials.
* Seek financing through sustainable finance instruments, potentially lowering capital costs by appealing to investors focused on environmental criteria.
This hypothetical example illustrates how climate risk directly informs Asset Allocation and operational planning in the real estate sector.

Practical Applications

Climate risk is increasingly integrated into various aspects of finance and economics. In Capital Markets, investors are demanding more transparency on how companies manage their climate exposures, influencing stock valuations and bond ratings. Regulatory bodies globally are implementing or proposing enhanced climate-related Disclosure Requirements to provide more consistent and comparable information to investors. For example, the European Central Bank announced in July 2025 that it would introduce a "climate factor" into its lending operations from late 2026, which could reduce the value of collateral depending on its exposure to climate-related shocks8, 9.

Banks are incorporating climate risk into their lending decisions, performing Stress Testing on loan portfolios to assess resilience under different climate scenarios. Insurers are adjusting premiums and coverage based on escalating physical risks, while asset managers are developing new financial products, such as climate-aligned funds, to meet investor demand for sustainable investments. The International Monetary Fund (IMF) emphasizes that financial institutions need tools to manage climate risks on their balance sheets to make informed business decisions and for supervisors to assess systemic risks6, 7. Brazil, for instance, is in talks with global asset managers to raise nearly $4 billion for climate-focused projects, indicating a growing trend in directing private capital towards climate solutions4, 5.

Limitations and Criticisms

While the importance of assessing climate risk is widely acknowledged, its practical application faces several limitations and criticisms. One significant challenge is the inherent uncertainty and long-term nature of climate projections, which makes precise Risk Assessment difficult. The models used for climate scenario analysis often rely on assumptions that may not fully capture the complexity and interconnectedness of climate impacts and economic responses.

Another criticism revolves around data availability and quality. Companies may lack the robust data necessary to accurately measure and report their climate-related risks, especially for indirect emissions (Scope 3) or complex supply chains. This can lead to inconsistencies and comparability issues in Financial Reporting. Additionally, the voluntary nature of many early disclosure frameworks, such as the TCFD recommendations (though now widely adopted and incorporated into mandatory standards), meant that disclosure was not uniform across all sectors or jurisdictions3. Even with mandatory Corporate Governance reporting, the subjectivity in assessing "materiality" of climate risks can still lead to variations in what is disclosed2.

Climate Risk vs. ESG

Climate risk is a specific subset of Environmental, Social, and Governance (ESG) considerations. While ESG is a broad framework used by investors to evaluate a company's sustainability and ethical impact, climate risk focuses solely on the financial impacts stemming from climate change.

FeatureClimate RiskESG
ScopeNarrow, focused on financial impacts of climate change (physical and transition risks).Broad, encompassing environmental, social, and governance factors.
FocusQuantifying and managing financial exposures related to climate.Assessing overall sustainability, ethical practices, and responsible corporate behavior.
ExamplesFlood damage to assets, carbon pricing policies affecting profitability.Labor practices, board diversity, data privacy, pollution control (broader).
MeasurementOften involves scenario analysis, carbon footprinting, and climate-related financial disclosures.Includes metrics for diversity, human rights, waste management, executive compensation, and more.

Understanding this distinction is vital for investors, as a company with a strong overall ESG profile might still have significant, unmanaged climate risk exposures if climate-specific impacts are not thoroughly assessed.

FAQs

What are the two main types of climate risk?

The two main types of climate risk are physical risk and transition risk. Physical risk refers to the direct financial impacts of climate-related hazards, such as extreme weather events like hurricanes, floods, and wildfires, as well as longer-term changes like sea-level rise. Transition risk, on the other hand, arises from the process of adjusting to a lower-carbon economy, including changes in policy and regulation, technological advancements, shifts in market sentiment, and reputational impacts on businesses1.

Why is climate risk important for investors?

Climate risk is important for investors because it can significantly affect the financial performance and long-term viability of their investments. Both physical and transition risks can lead to decreased asset values, increased operational costs, supply chain disruptions, and reputational damage. By assessing climate risk, investors can make more informed decisions, incorporate these factors into their Investment Strategy, and potentially identify new opportunities in the transition to a sustainable economy.

How do companies manage climate risk?

Companies manage climate risk through various strategies, including implementing robust Corporate Governance frameworks for oversight of climate-related issues, developing strategies to mitigate or adapt to identified risks, setting climate-related targets and goals, and disclosing their exposure and management approaches to investors and regulators. This often involves integrating climate risk into broader Risk Assessment processes and financial planning. Some companies also invest in resilient infrastructure or explore new, low-carbon business models.