Quantifying climate risk: a strategic imperative for capital markets

Recent reports confirm that financial markets are increasingly factoring climate risk into lending decisions and interest rates. Oliver Carpenter, VP Environmental Analytics at Risilience, considers how this significant economic shift is impacting markets and affecting bottom lines.

Despite a slower pace of policy implementation to reduce greenhouse gas emissions, financial markets are actively incorporating both physical and transition risks into asset pricing and credit decisions. Climate change is no longer a distant or abstract concern; it is a current and material financial risk. Capital markets are increasingly reflecting this reality through higher borrowing costs, collateral frameworks, and risk-weighted capital requirements.

Climate risk is translating into higher cost of debt

Research from the Central Bank of Ireland, analysing €12.7 billion in corporate credit exposure, found that firms located in areas with elevated flood risk pay a premium of seven to 13 basis points on borrowing costs. In short, companies exposed to higher physical climate risks are already paying more for capital.

Further, the European Central Bank recently found that banks with higher exposure to carbon-intensive borrowers are penalised with higher borrowing rates due to increased transition risk. In the crucial market for short-term interbank lending, a bank with significantly higher financed emissions had to pay an interest rate that was, on average, 7% to 12% higher than its less-exposed peers.

The impact is systemic. Significantly, the financial markets are now responding measurably to both physical and transition risks. Both financial institutions and corporates with elevated climate-related exposures are facing demonstrably higher funding costs, adding pressure at a time when corporate leverage remains historically elevated. With corporate debt peaking at over 90% of US GDP in 2020, balance sheets are particularly sensitive to incremental increases in interest rates and credit spreads.

In a disorderly or accelerated transition scenario, unprepared companies face compounded downside risk:

• Investors and lenders price in transition and physical risk premiums.

• Broader macroeconomic disruption may drive inflationary pressure, interest rate volatility and tighter financial conditions.

Importantly, even firms with minimal debt are not insulated. If suppliers are hit with higher borrowing costs, they may seek to pass these on through increased pricing. Likewise, demand may weaken if customers face tighter credit conditions. Climate risk transmits across value chains, not just balance sheets.

In response, market feedback indicates that many banks are already incorporating climate risk metrics into internal credit scoring models, with others actively preparing to do so. The regulators are responding too – from 2026, the European Central Bank (ECB) will apply a “climate factor” to adjust collateral valuations used in its lending operations. In parallel, additional capital charges will apply to regulated banks where material climate transition risk is identified within their loan books.

This strengthens the case for enhanced transparency and climate-related reporting requirements.

Firm-level ESG scores are no longer sufficient

Broad ESG ratings lack the granularity required for capital allocation decisions. Climate risks are highly asset-specific, geography-dependent, and industry-sensitive. Therefore, effective risk assessment requires quantitative, granular modelling of both:

• Transition risks, which are typically policy-driven and highly jurisdiction- and sector-specific.

• Physical risks, which are geographically determined and are asset- and operation-specific due to unique vulnerabilities of economic activities.

Risk analysis must extend beyond the individual firm to encompass supply chains and value chains. This broader lens enables more informed strategic decisions, supports risk-adjusted capital allocation, and can reduce the embedded climate risk premium in borrowing costs.

Proactive risk management creates financial advantage

Corporates that systematically measure, manage and disclose physical and transition risks are better positioned to mitigate financing penalties, strengthen resilience, and unlock long-term value. A credible, data-driven transition plan is no longer a nice-to-have. It is a financial necessity.

Companies engaged in climate solutions will see growth opportunities in a low-carbon transition. These firms are already being rewarded by the market with a “green premium”. Because they are seen as a hedge against transition risk, investors are willing to pay more for their stock. This results in lower expected returns for the investor but reduces the company’s cost of capital, creating a tangible financial advantage.

Implications for banks and private equity

For banks and private equity (PE) firms, climate risk assessment must span the full investment lifecycle – from origination and sector screening through due diligence, portfolio monitoring, and exit planning.

Where exposure is poorly understood or inadequately quantified, investors apply an “uncertainty premium.” This translates into higher required returns and elevated capital costs, as lenders and LPs demand compensation for opaque or unmanaged climate exposure.

Robust financial quantification is therefore critical. Granular analysis at sector, geography, and revenue-band level provides visibility into concentrated risk exposures and informs strategic portfolio decisions, including capital deployment and divestment strategy.

Advanced analytics that quantify climate-related financial risk across entire value chains gives banks and PE firms line-of-sight into otherwise hidden cost pressures. This transparency is no longer optional; it is essential for disciplined capital allocation, improves risk-adjusted returns, and stronger exit valuations.

• Learn more about how to financially quantify climate and nature-related risk and opportunity to build business resilience and growth. Get in touch with a member of the Risilience team.

• Meet the Risilience team at Greenbiz, (Booth 204), 17–19 February, Phoenix, AZ, where our VP Sales Americas, Saim Ghouse, will take part in the session ‘Translating Sustainability: How to Speak Your CFO’s Language’, Wednesday 18th February, at 9am (MST).