Climate Financial Risk 101

When an investor funds a venture, they do so with the hopes of earning more than they invested. However, investors risk financial loss if the venture underperforms or fails. This trade-off between risk and return is a fundamental consideration in any investment and leads investors to demand higher possible rewards for higher-risk investments. The presence and management of financial risk is ubiquitous across all sectors of the economy, although what that risk looks like differs by sector and by individual investment.

As climate change warms the planet and actions are taken to reduce emissions, financial institutions must reckon with new and changing risks to assets and the broader financial system. This explainer will discuss the risks that climate change poses to financial systems and stakeholders, as well as actions to accurately account for these risks.

Physical Risks

Climate change is linked to rising temperatures and sea levels; changing precipitation; volatile weather; and an increase in the size and intensity of natural disasters like wildfires, hurricanes, and heatwaves. These events have and will continue to damage assets and infrastructure, displace communities, and disrupt supply chains and business operations. The risk carried by these changes is called physical risk.

A substantial amount of persistent, climate-related physical change is already “baked in” to geophysical systems: carbon dioxide, the main driver of climate change, remains in the atmosphere for hundreds of years after it is emitted and drives changes in physical risk for several decades. Therefore, for many institutions, the question is not only how to stop the physical changes from happening, but also how to account for and limit exposure to them.

Businesses face substantial physical risks from climate change. Even if a business’ assets (such as buildings, equipment, and vehicles) remain undamaged by an extreme weather event, these events can lead to productivity loss (particularly in agriculture) and supply-chain issues. For example, of the nearly $150 billion in estimated damages from California’s 2018 wildfires, approximately 60 percent were indirect losses caused by disrupted economic activity.

Households and real estate assets are also at risk. Property damage is the most immediate source of risk, and as home equity represents almost a third of US wealth, property damage or loss can have significant repercussions on the US economy. Natural disasters are also associated with an increase in credit card debt, debt collection, mortgage delinquency, and foreclosure. Households that are already financially unstable or who exist in underserved communities tend to experience these problems most acutely, and are also most likely to live in places that will feel the worst impacts of climate change.

Local governments will face notable challenges from climate-related physical change as well. This can involve the risk of destruction of large-scale community infrastructure such as roads, bridges, and public buildings that must be replaced, and impacts on municipal budgets. Research has shown that climate change can increase the likelihood of local budget deficits and scarce resources. A 2022 study by scholars affiliated with Resources for the Future (RFF) found that California wildfires between 1990 and 2015 caused a long-term increase in local government spending and had a negative and significant impact on municipal budgets.

Insurance providers may have to contend with losses as they pay out many large claims after natural disasters. Insurance is designed under the assumption that risks are predictable and that only a portion of those paying premiums will file claims at one time. As a larger portion of people and properties are likely to be affected by natural disasters in the future, changing risks and payout structures could cause major problems and, down the road, make insuring types of risk unaffordable for customers and/or impractical for insurers. Notably, about 95 percent of flood insurance in the United States is provided by the federal government through the National Flood Insurance Program (NFIP), often at a subsidized rate; the risk is deemed uninsurable by private insurers at rates affordable to typical households. However, major storms in recent years have driven the NFIP deficit to over $20 billion, prompting calls for reform.

Transition Risk

Limiting further climate change will require significant changes to the global energy system, other greenhouse gas-emitting activities, and throughout the economy. The risks that accompany an uncertain path to a decarbonized economy are called transition risks. How intense transition risk is, and where it will be felt the most, will be influenced by both government policy action (or inaction) to drive mitigation and the potentially changing expectations of the private sector—including investors—about future policy actions. These forces can contribute to transition risk via both underinvesting and investing too quickly in low- vs high-emitting activities when the profitability of business models depends on uncertain public policy and customer demand.

Businesses may suffer from significant losses in the transition to net-zero emissions if their production or business models rely on greenhouse gas-intensive raw materials or processes. Among other considerations, businesses face the risk of their assets becoming “stranded.” Stranded assets are durable assets that may become unusable or prematurely decommissioned due to policy or market changes after a company has made an initial investment. For example, a company that builds an expensive power plant with the intention of recouping costs over the next few decades may later encounter regulations that make the plant unprofitable, rendering the asset “stranded” as the company can no longer recoup its initial costs as expected.

Local governments can face significant transition risk if their finances are built around industries, such as oil and gas production and refining, that emit substantial greenhouse gases. A 2022 RFF working paper, for example, found that fossil fuels are responsible for approximately $85.2 billion in revenue each year for US municipalities, states, and tribes. And although revenue streams for fossil fuel communities are expected to dwindle both with and without future climate action, the uncertain nature of the low-carbon transition poses a further risk for communities that have historically relied on these funds to support infrastructure projects, education, and public health.

The impacts of physical and transitional risk range from profit losses and higher default risks for individual companies and investors to broad concerns over the stability of the system and burden on the public. This section details those impacts.

Higher Cost of Capital

When a municipality faces severe infrastructure damage from a natural disaster, or when a company suffers from major profit losses in the energy transition, the likelihood of it defaulting on its debt or declaring bankruptcy increases. Considering these higher default risks, investors often demand a higher return on the investment and increase the at-risk borrower’s cost of raising capital. The degree of this increase depends on investor knowledge about the borrower’s climate risk exposure and the borrower’s actions to mitigate these risks.

Recent studies show that climate-related impacts on the cost of capital are already emerging. Municipalities hit by one or more hurricanes saw their municipal debts downgraded by rating agencies, and those with more sea level rise exposure are paying higher yields, especially on long-term bonds. Similarly, firms with higher carbon emissions may also need to provide higher returns on their stocks, consistent with lower investor demand for stocks of these companies.

Systemic Risk and the Stability of the Financial System

In finance, systemic risk refers to a broad risk of failure across the financial system. Such failure can arise from one major shock leading to a series of cascading failures within the financial system, or different parts of the financial system facing highly correlated risks. The 2008 financial crisis is a case in point where initial problems with mortgage-backed securities were amplified and spread by financial institutions.

Climate change has the potential to trigger such failures, as recognized by the Financial Stability Oversight Council (FSOC), the US Commodity Futures Trading Commission (CFTC), and others. Its broad impacts are further complicated by the deep uncertainties about the climate’s future, which hinders financial markets’ ability to price assets to properly reflect the relevant risks. Surveys show that financial professionals believe climate risks are underevaluated in asset prices. As a result, prices of a large class of assets could be sensitive to major updates in climate science, extreme weather events, and changes in climate policy. These sensitivities increase the possibility for disorderly price adjustments and spillover effects to other financial markets and the flow of goods and services. However, the timescale of climate change might allow sufficient time for assets to adjust given the typical investment horizon.

Burden on the Public

Climate risks carry ramifications for the general public, including those who are not active financial market participants. Investments from pension funds and retirement savings are subject to the same risks as other investors. Furthermore, taxpayer dollars are at stake through the federal government’s role as the main provider of mortgage guarantees, flood insurance, crop insurance, disaster aid, and other social programs, and as the insurer of last resort to the financial sector in extreme events such as the 2008 financial crisis. In addition, if climate-related financial risks lead to a general economic downturn, millions will suffer from significant welfare losses and economic hardship.

A key policy option to lower both transition and physical risks is to implement federal carbon pricing and similar climate policies consistent with national mitigation goals that facilitate orderly capital flow toward sustainable economic activities. However, firms, investors, financial regulators, and other groups still need proper knowledge of their exposure to both types of risks to properly manage them. That is, once new policies are in place, climate change will still occur, and the future path of those policies cannot be known with certainty. This next section covers financial market policies that might support sound assessment of climate financial risks by different entities.

Disclosure

Disclosure is the process by which an entity reports its assets, liabilities, and risks. Financial regulators across the world generally require disclosures of key financial information from public companies to help investors make informed decisions. In a climate context, this could include greenhouse gas emissions (both direct and in its supply chain), exposure to climate impacts such as flooding and wildfires, and management practices to address physical and transition risks. As the climate changes, these metrics are becoming increasingly relevant for investment decisions; for example, an investor in a state with stringent climate policies should be less inclined to invest in a business with relatively high carbon emissions.

In the United States, the Securities and Exchange Commission (SEC) announced a landmark proposal in March 2022 that would require public companies to disclosure their climate-related financial risk. Most would have to disclose their greenhouse gas emissions, requiring significant changes in the “environmental, social, and governance” (ESG) disclosure framework from US companies. For more on the SEC climate disclosure rule, read this Resources blog series that breaks down the proposed rule in detail.

International institutions have also set up similar protocols to measure climate risk. The European Union’s Sustainable Finance Disclosure Regulation, which has been in effect since March 2021, provides an avenue for investors to analyze investment funds’ environmental sustainability measures.

Some of the most widely used standards for measuring climate commitments and climate-related risks of companies are spearheaded by international nonprofit organizations. The Corporate Climate Responsibility Monitor, for example, assesses the integrity and transparency of climate pledges. Other groups, such as the Task Force on Climate-related Financial Disclosures, the Sustainability Accounting Standards Board, and the International Sustainability Standards Board, are working to accurately measure companies’ climate commitments and investment decisions.

Climate Stress Testing

Stress testing is a standard tool used by financial institutions and regulators to assess financial resilience in adverse scenarios such as a recession. This approach is recognized as an essential tool to analyze exposure to climate-related financial risks. Most proposed and ongoing climate stress tests take the form of a scenario analysis, which applies a set of forward-looking scenarios that capture plausible future states of climate change and climate policies and evaluates a financial entity’s performance in them. The Network for Greening the Financial System (NGFS), a network of several dozen central banks and financial supervisors, has issued official guidance on climate scenario analysis for financial regulators. As of spring 2022, adopters of climate stress testing include the Netherlands, France, the European Central Bank, Canada, Australia, and the United Kingdom. US financial regulators, such as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve, are also developing principles and infrastructure for climate stress testing.

Existing climate stress tests face several major challenges. For instance, the accuracy of the findings is limited by the availability and quality of firm-level data on physical risk factors and carbon intensity, which is not consistently reported at present. Further research is needed to refine modeling over a long time horizon and to improve the plausibility and relevance of the scenarios.

Climate change poses significant risks to global financial systems and those that rely on them. Reducing uncertainty about the pace of climate change and policy, as well as improving entities’ ability to accurately assess risk, will be imperative to mitigating climate financial risks now and in the future.

The authors would like to thank RFF scholars Billy Pizer and Marc Hafstead for their invaluable input on this explainer.