Climate change has transcended from being viewed solely as an environmental issue to becoming a pressing financial concern, reshaping the landscape of investment and lending decisions. Banks and institutional investors must recognize the significance of climate risks and integrate them into their investment decisions, risk management processes, disclosures, and operational practices.

Importantly, climate-related risk trajectories and transmission channels differ across investor classes. The key question is which climate risks are material to which types of investors and how and when these could affect their investments.

Mapping the Climate Risk Trajectory

The potential impacts of climate change on financial systems manifest through two primary channels: physical risk and transition risk. Physical risk relates to damage caused to property, land, and infrastructure by extreme weather and natural disasters. In contrast, transition risk relates to regulatory, legal, and market changes associated with a global transition to lower carbon emissions.

Both types of risk will likely rise over the next two decades, with transition risk escalating with efforts to mitigate carbon emissions and physical risk manifesting as global temperatures rise. After 2050, physical risk is expected to dominate, though transition risk will also persist if climate action falls short before this date. Physical risks are greater in developing countries, including India, which are vulnerable to and have limited ability to adapt to climate impacts.  

Banks Are More Vulnerable to Physical Risks than Transition Risk

Banks are among those financial institutions that are particularly vulnerable to physical risks, which can arise directly through their exposure to businesses, households, and economies affected by climate events. Banks may also be exposed to the ripple effects within the financial system of the economic consequences of climate change.

Physical climate risks may cause banks’ assets to diminish in value, and the default risk of their loan portfolios to rise. For example, banks could face significant risk to their mortgage portfolios if they provide capital to housing assets exposed to flooding or water scarcity, as has already been observed in Indian cities. These properties could yield reduced rental income and depreciate.

While such physical risks can disrupt businesses and household incomes at any time, banks’ short- to medium-term lending periods enhance their ability to avoid more gradually materializing transition risks.

While not as significant for banks as physical risks, transition risks present challenges related to paying for negative externalities produced by investee companies or borrowers. For example, financial regulators nudge banks and financial institutions to incorporate greenhouse gas (GHG) emissions into their pricing of loans and investments. The goal is to increase the cost of loans for high-emitting companies, encouraging them to reduce their environmental impacts. However, this may not be a significant risk for banks as borrowers may not pay for negative externalities in the short to medium term. Governments are likely to gradually increase carbon pricing within countries so as not to jolt their economies.

Climate Change Risks Affect Institutional Investors’ Assets, and Insurance Companies Have Both Asset and Liability Exposures

Institutional investors, including insurers, reinsurers, pension funds, and mutual funds, are exposed to physical and transition risks. Transition risk materializes on the asset side from exposure to companies with business models not aligned with low-carbon economics. Fossil fuel producers, for example, may experience reduced earnings, business interruptions, and higher funding expenses due to policy measures and technological advancements in clean energy. Regarding physical risks, business disruptions and decreases in household income due to climate-induced weather events can reduce the financial asset (e.g. equity, bond, loans, etc.) value of these investors.

In addition, insurance companies face substantial liability exposure arising from the potential for increased insurance claims due to natural disasters. Given India’s high vulnerability to climate-induced physical risks, including floods, precipitation, storms, and water scarcity, insurance payouts may spike, requiring insurance premiums to be priced properly.

Why Equity Investors Should Be More Concerned About Transition Risk

For equity investors, returns depend not just on yield (dividends) but also on capital appreciation due to the potential for sustainable profit generation over a long period. If investee companies are not integrating climate change considerations into their business decision-making, the long-term sustainability of their profits may be challenged. Even if equity investors are currently earning high returns from carbon-emitting stocks, market perceptions may not continue to overlook climate risks for the duration of the investment horizon. With widespread scientific consensus on climate change, governments seek to transition to lower carbon economies by imposing carbon taxes or carbon pricing (e.g., cap and trade mechanisms) on companies for their emissions. While the timing of this transition remains uncertain and variable across countries, and current carbon prices are low, they are anticipated to rise in the future as governments pursue strategies to reduce carbon intensity and achieve net-zero emissions.

Increases in carbon prices, whether sudden or gradual, can dent capital appreciation and even depreciate financial asset value. Hence, investors must be cognizant of the government’s carbon pricing pathway, which could eventually materialize.

While physical risk is also important to equity investors, it does not entirely materialize as a financial risk for investors if the investee corporations, particularly large corporations, have taken steps to make their business operations resilient to physical risks as part of their day-to-day operations and enterprise risk management, for example, by buying insurance to protect assets. However, equity investors need to be cautious, as the investee corporations may not be taking measures now or do not have plans to mitigate physical risks. Physical risks are more 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.

Case When Climate Risk Is Not Considered an Investment Risk

There are instances where climate risk may not be perceived as an investment risk, especially when externalities have not been adequately addressed. This is particularly relevant to transition risks, as companies producing negative externalities often do not pay for the resulting damages, effectively escaping accountability for their environmental impacts. Even if the government signals intention to impose penalties on companies for their negative externalities, e.g., by taxing GHG emissions, investors may discount this risk if the government action is expected to materialize beyond the investment cycle or if companies can transfer the carbon tax or carbon pricing costs to users of their products (consumers or other corporates) by using their bargaining power and vertical relationships (contractual arrangements). In such cases, climate transition risks may not materialize in their investments.

Nevertheless, it would be unwise for all types of investors to disregard transition risks in carbon-intensive industries amid evolving government climate action. As the climate crisis deepens, governments may accelerate and take increasingly stringent mitigation measures, escalating transition risk. In addition, physical risks should not be overlooked by lenders and investors with short- to medium-term investment horizons.  Investors must acknowledge that climate change can have immediate and significant impacts on businesses and investment portfolios. Ignoring climate change risks is no longer an option. Investors can nudge their investee corporations, in their stewardship capacity, to embrace climate change in the business decision-making process. By integrating climate change into decision-making, corporations will mitigate climate risks and position themselves as drivers of positive change, which is no longer a choice but a strategic necessity.