Climate Finance and Risk

Module 3: Climate Finance and Risk

Understanding Climate Risk in Finance

Climate change is not just an environmental issue—it's a financial issue. The physical impacts of climate change and the economic transition required to address it create material risks for companies, investors, and financial institutions.

In 2015, Mark Carney, then Governor of the Bank of England, warned of the "tragedy of the horizon"—the mismatch between the long-term nature of climate change and shorter-term horizons of most financial and political decision-making. Since then, climate risk has moved to the center of financial regulation and investment analysis.

Types of Climate Risk

Climate risks are typically categorized into three types:

Physical Risks

Physical risks arise from the direct impacts of climate change on assets, operations, and economies:

Acute Risks: Event-driven risks from extreme weather

• Hurricanes and typhoons
• Floods and storm surges
• Wildfires
• Extreme heat events
• Droughts

Chronic Risks: Longer-term shifts in climate patterns

• Sea level rise
• Changing precipitation patterns
• Rising average temperatures
• Ocean acidification
• Ecosystem degradation

Physical risks affect property values, agricultural productivity, supply chains, labor productivity, and insurance costs. They're already materializing—global insured losses from natural catastrophes have trended upward over recent decades.

Transition Risks

Transition risks arise from the shift to a lower-carbon economy:

Policy and Legal Risks

• Carbon taxes and emissions trading
• Regulations on emissions, efficiency, or activities
• Litigation against high-emitting companies
• Mandates for clean technologies

Technology Risks

• Disruption from cleaner technologies
• R&D investment requirements
• Early retirement of existing assets
• Competitiveness shifts

Market Risks

• Changing consumer preferences
• Shifting investor demands
• Repricing of assets
• Changes in demand for products

Reputation Risks

• Stakeholder concerns about climate strategy
• Stigmatization of carbon-intensive sectors
• Loss of social license to operate

Liability Risks

The third category, sometimes included within transition risks, covers:

• Climate litigation against companies
• Failure-to-adapt claims
• Misrepresentation claims (greenwashing litigation)
• Directors' duties cases

Stranded Assets

A key concept in climate risk is "stranded assets"—assets that lose value or become obsolete earlier than expected due to climate-related factors.

Examples include:

• Fossil fuel reserves that can't be burned under climate constraints
• Coal power plants retired early due to renewable competition
• Coastal real estate affected by sea level rise
• Agricultural land in areas becoming less productive

The Carbon Tracker Initiative has estimated that achieving climate goals could leave trillions of dollars of fossil fuel assets stranded. This has significant implications for energy companies, their investors, and the broader financial system.

Climate Scenario Analysis

Financial institutions increasingly use climate scenario analysis to assess risks under different future pathways:

Common Scenarios

Orderly Transition: Strong, early policy action leads to smooth transition. Low physical risks, moderate transition risks.

Disorderly Transition: Delayed or divergent policy action leads to sudden, disruptive changes. Moderate physical risks, high transition risks.

Hot House World: Limited policy action leads to significant warming. High physical risks, low transition risks.

Net Zero by 2050: Aggressive action achieves Paris Agreement goals. Requires rapid transformation across all sectors.

Using Scenarios

Scenarios aren't predictions—they're tools for exploring how different futures might affect portfolios and businesses. Organizations use them to:

• Identify vulnerabilities
• Test strategy resilience
• Inform capital allocation
• Guide engagement with companies
• Meet regulatory requirements

The Task Force on Climate-related Financial Disclosures (TCFD)

The TCFD, established by the Financial Stability Board in 2015, created a framework for climate-related financial disclosures that has become the global standard.

Four Core Pillars

Governance

• Board oversight of climate risks and opportunities
• Management's role in assessing and managing climate issues

Strategy

• Climate-related risks and opportunities identified
• Impact on business, strategy, and financial planning
• Resilience under different climate scenarios

Risk Management

• Processes for identifying and assessing climate risks
• Processes for managing climate risks
• Integration with overall risk management

Metrics and Targets

• Metrics used to assess climate risks and opportunities
• Scope 1, 2, and (where relevant) 3 greenhouse gas emissions
• Targets and progress against targets

The TCFD framework has been incorporated into regulations in many jurisdictions and adopted voluntarily by thousands of organizations.

Climate Risk Assessment Methods

Portfolio Carbon Footprinting

Measuring the carbon emissions associated with investment portfolios:

• Scope 1: Direct emissions from owned/controlled sources
• Scope 2: Indirect emissions from purchased energy
• Scope 3: All other indirect emissions in the value chain

Common metrics include:

• Total carbon emissions
• Carbon intensity (emissions per revenue or per investment)
• Weighted Average Carbon Intensity (WACI)

Physical Risk Assessment

Tools and data providers offer assessments of physical climate risks by:

• Mapping asset locations to climate hazards
• Projecting changes in hazard frequency/severity
• Estimating financial impacts under different warming scenarios

Transition Risk Assessment

Evaluating company exposure to transition risks through:

• Sector exposure analysis
• Carbon intensity relative to peers
• Revenue from high-risk products
• Capital expenditure alignment with climate goals
• Management quality and transition planning

Climate Finance Flows

Beyond risk management, climate finance involves actively directing capital toward climate solutions:

Mitigation Finance

Funding activities that reduce or prevent greenhouse gas emissions:

• Renewable energy
• Energy efficiency
• Electric vehicles and sustainable transportation
• Industrial decarbonization
• Sustainable land use

Adaptation Finance

Funding activities that help societies adapt to climate impacts:

• Climate-resilient infrastructure
• Water management systems
• Drought-resistant agriculture
• Coastal protection
• Early warning systems

Climate Finance Gap

While climate finance has grown significantly, it remains well below what's needed:

• Current climate finance: ~$1 trillion annually
• Estimated need: $4-7 trillion annually by 2030

Closing this gap is one of the central challenges of climate finance.

Carbon Accounting

Understanding carbon emissions is fundamental to climate finance:

Scope Categories

Scope 1: Direct emissions from sources owned or controlled by the company (e.g., fuel burned in company vehicles or manufacturing)

Scope 2: Indirect emissions from purchased electricity, steam, heating, and cooling

Scope 3: All other indirect emissions in the value chain, both upstream (suppliers, business travel) and downstream (product use, end-of-life treatment)

For financial institutions, "financed emissions"—the emissions associated with loans and investments—are a type of Scope 3 emissions that have become increasingly important.

Carbon Accounting Standards

The Greenhouse Gas Protocol provides the primary accounting standards used globally. Key principles include:

• Relevance
• Completeness
• Consistency
• Transparency
• Accuracy

Net Zero Commitments

Many financial institutions have made net-zero commitments:

Net-Zero Asset Owner Alliance: Asset owners committing to net-zero portfolios by 2050

Net-Zero Asset Managers Initiative: Asset managers committing to support net-zero investing

Net-Zero Banking Alliance: Banks committing to align lending and investment with net-zero by 2050

These commitments require:

• Setting intermediate targets
• Measuring and reporting portfolio emissions
• Engaging with high-emitting companies
• Shifting capital allocation over time

Regulatory Developments

Climate risk regulation is expanding rapidly:

Disclosure Requirements

• EU Corporate Sustainability Reporting Directive (CSRD)
• US SEC climate disclosure rules
• UK mandatory TCFD disclosures
• ISSB global sustainability standards

Prudential Regulation

• Climate stress testing for banks and insurers
• Capital requirements considering climate risks
• Supervisory expectations on climate risk management

Taxonomies

• EU Taxonomy defining sustainable activities
• National taxonomies in China, UK, and other markets

Practical Applications

For Investors

• Screen portfolios for climate risk exposure
• Engage with companies on climate strategy
• Shift allocation toward climate solutions
• Use climate data in investment analysis

For Companies

• Assess and disclose climate risks
• Develop transition plans
• Set science-based targets
• Access green financing for climate investments

For Financial Institutions

• Integrate climate into credit analysis
• Develop climate-related financial products
• Manage portfolio-level climate exposure
• Meet regulatory requirements

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In the next module, we'll explore carbon markets and pricing—the mechanisms that put a price on carbon to incentivize emissions reductions.