Climate change is no longer viewed simply as an environmental issue but as a pressing financial issue, reshaping investment and lending decisions. Banks and institutional investors must recognize the importance of climate risk and integrate it into investment decisions, risk management processes, disclosures and operating practices.
Importantly, the trajectories and transmission channels of climate-related risks differ across investor categories. The key questions are which climate risks matter to which types of investors, and how and when these risks impact their investments.
Mapping climate risk trajectories
The potential impact of climate change on the financial system is manifested through two main channels: physical risk and transition risk. Physical risks involve damage to property, land and infrastructure caused by extreme weather and natural disasters. In contrast, transition risks relate to regulatory, legal and market changes related to the global transition to low carbon emissions.
Both types of risk are likely to rise over the next two decades, with transition risks escalating as efforts to reduce carbon emissions occur, and physical risks emerging as global temperatures rise. After 2050, physical risks are expected to dominate, but if climate action is insufficient before this date, transition risks will also persist. Natural risks are greater in developing countries, including India, which are vulnerable to climate impacts and have limited capacity to adapt to them.
Banks are more exposed to physical risks than transition risks
Banks are among the financial institutions that are particularly vulnerable to physical risks that may arise directly from their exposure to businesses, households and economies affected by climate events. Banks may also face the knock-on effects of the economic consequences of climate change across the financial system.
Natural climate risks can lead to a decline in the value of bank assets and an increase in the default risk of loan portfolios. For example, a bank's mortgage portfolio may be exposed to significant risks if it funds housing assets that are at risk of flooding or water scarcity, as has been observed in Indian cities. These properties may reduce rental income and depreciate in value.
While such physical risks could disrupt business and household incomes at any time, banks' short- to medium-term loan maturities enhance their ability to avoid emerging transition risks.
While transition risk is not as important to banks as physical risk, it poses challenges related to paying for negative externalities generated by investee companies or borrowers. For example, financial regulators are urging banks and financial institutions to incorporate greenhouse gas (GHG) emissions into the pricing of their loans and investments. The goal is to make loans more expensive for high-emitting companies and encourage them to reduce their environmental impact. However, this may not be a significant risk for banks as borrowers may not pay the price of negative externalities in the short to medium term. Governments may gradually increase domestic carbon pricing to avoid hitting the economy.
Climate change risks affect the assets of institutional investors, and insurance companies’ assets and liabilities coexist with risks
Institutional investors, including insurance companies, reinsurers, pension funds and mutual funds, face physical and transition risks. Transition risks on the asset side arise from companies whose business models are not aligned with a low-carbon economy. For example, fossil fuel producers may face reduced revenues, business disruptions and increased financing expenses as a result of policy measures and technological advances in clean energy. In terms of physical risks, business disruptions and reduced household incomes caused by climate-induced weather events could reduce the value of these investors’ financial assets (e.g., equity, bonds, loans, etc.).
In addition, insurance companies face significant liability exposure as natural disasters can lead to an increase in insurance claims. Given India's high vulnerability to climate-induced natural risks, including floods, precipitation, storms and water shortages, insurance claims are likely to surge, necessitating appropriate pricing of insurance premiums.
Why equity investors should pay more attention to transition risks
For stock investors, returns are determined not only by yield (dividends) but also by capital appreciation due to the potential for sustainable profits over the long term. If investee companies do not integrate climate change considerations into their business decisions, the long-term sustainability of their profits may be challenged. Even if equity investors are currently reaping high returns from carbon-emitting stocks, market perceptions may not continue to ignore climate risks over the investment period. With widespread scientific consensus on climate change, governments are seeking to transition to a low-carbon economy through carbon taxes or carbon pricing (such as cap-and-trade mechanisms) on companies' emissions. While the timing of this transition remains uncertain and variable across countries, and current carbon prices are low, future carbon prices are expected to increase as governments adopt strategies to reduce carbon intensity and achieve net-zero emissions. rise.
Increases in carbon prices, whether sudden or gradual, can reduce capital appreciation and even depreciate the value of financial assets. Therefore, investors must recognize that the government’s path to carbon pricing may eventually materialize.
While physical risk is also important to equity investors, it becomes more important to investors if investee companies, especially larger ones, take steps to make their business operations resilient to physical risk as part of their day-to-day operations. Doesn't exactly manifest as financial risk. Equity investors need to be cautious, however, as investee companies may not have measures in place now, or plans to mitigate physical risks. Physical risk is more problematic for companies where location determines the value of assets. For example, the value of a property or port depends on the suitability of the location – natural risks such as floods, storms, cyclones, water shortages and rising sea levels can erode the value of these assets.
The case for climate risk not being considered an investment risk
In some cases, climate risk may not be considered an investment risk, particularly where externalities have not been adequately addressed. This is particularly relevant to transition risk, as companies that generate negative externalities often fail to pay for the resulting damage, effectively escaping responsibility for their environmental impacts. That is, governments use their bargaining power and vertical relationships (contractual arrangements) to set prices for the users of their products (consumers or other companies). in this case, Climate transition risks may not be reflected in their investments.
However, amid ever-changing government climate action, investors of all types would be unwise to ignore the transition risks of carbon-intensive industries. As the climate crisis deepens, governments are likely to accelerate increasingly stringent mitigation measures, exacerbating transition risks. Additionally, lenders and investors with short- to medium-term investment horizons should not ignore physical risks. Investors must acknowledge that climate change can have direct and significant impacts on businesses and investment portfolios. Ignoring the risks of climate change is no longer an option. Investors can use their management capabilities to drive their investee companies to embrace climate change in their business decision-making processes. By integrating climate change into decision-making, companies will mitigate climate risks and position themselves as agents of positive change, no longer a choice but a strategic necessity.
