2.2 How to face the climate risks that could break the market
· 13 min read
This article is part of the Sustainable Finance Guide, a new series by Globalfields in collaboration with illuminem. Together, we provide readers with clear, educational insights into where sustainable finance stands today and how it is evolving to support nature, regeneration, and long-term resilience.
In his 2015 speech, the former governor of the Bank of England, Mark Carney, warned that climate change was a tragedy of horizons.
He was referring to the fact that the impact of climate change would be felt beyond the traditional horizons of most of the actors in the financial sector, beyond business and political cycles and the horizons of authorities like central banks, who are bound by their mandates [1].
By 2015, the financial system was already facing the cumulative risks posed by the climate crisis, and alarms were being raised, mostly by the insurance industry. Even a decade ago, the inflation-adjusted insurance losses from weather-related events had increased from USD 10 billion to USD 50 billion since the 1980s [2]. This foresight was already being validated by mounting data.
Today, climate change is not a distant concern but a defining issue for financial stability.
Recent studies show that each 1°C increase in global temperature can be linked to a 12% decline in global GDP [3]. The threats run deep as banks face an increased risk of non-performing loans, insurers face higher liability risks, and investors must grapple with potential asset devaluation and market shocks. Stranded assets and the physical risks of climate change are the key challenges facing corporations.
It is becoming increasingly clear that the world requires a financial system that plays a central role in facilitating disclosure, investments in mitigation and adaptation, and risk management tools (such as stress testing) to address the climate-related risks facing the financial sector.
Adapting to climate change and the transition to a net-zero economy requires a strategic systems change approach. The consequences of both these events will reverberate across the financial system, amplified by the spillover effect of the financial system and its deep interlinkages [4].
Although the exact future pathways of impact for climate-related risks are uncertain, the resulting potential systemic risk for the financial system has been highlighted by almost all international and national financial supervisors [5]. To understand how climate change endangers financial stability, it is important to distinguish between the different types of risks it poses to financial actors and systems.
Physical risks from climate change relate to damage caused to property, land, and infrastructure by extreme weather and natural disasters, which are caused or exacerbated by climate change [6].
One of the most immediate consequences of climate change is the increasing frequency and severity of acute weather events like flooding, droughts and storms. Such events can be categorised into rapid onset events like floods, or slow onset ones, such as famines and gradual shifts in climate patterns. Both disrupt asset prices, loan performance, and supply chain operations over different time horizons.
Physical risks affect livelihoods and supply chains directly through losses or by increasing insurance premiums for weather-related events. Annual global direct damages from these weather-related hazards have more than doubled in real terms from the early 2000s and reached USD 275 billion in 2022 [7].
Even more alarming are climate tipping points.
These are critical thresholds in the Earth’s system that can trigger abrupt, systemic shocks that ripple across economies, asset classes, and global markets. From the collapse of polar ice sheets leading to rapid sea level rise, to the disruption of the Atlantic Ocean circulation, all these events could disrupt the financial system in unpredictable ways. Developing countries and emerging economies remain the most vulnerable and exposed to physical risks, which is further constrained by their limited adaptive capacity
These physical effects cascade into tangible financial consequences for institutional stakeholders. Institutional investors (including insurers, reinsurers, pension funds, and mutual funds) see the value of assets eroded by climate-induced shocks. In addition, insurance companies face substantial liability exposure arising from the potential for increased insurance claims due to natural disasters [8]. Indeed, from 1980 to 2015, insurance companies bore 26% of global losses attributed to natural disasters, highlighting the profound effect of physical risks on the insurance sector [9].
Banks, too, are vulnerable to physical risks via their exposure to businesses, households, and economies affected by climate events. 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, which could result in reduced rental income and depreciation [10].
Physical risks expose how environmental volatility can destabilise finance itself, whereas transition risks emerge from the systemic changes required to mitigate this volatility.
In contrast to physical risk, transition risk relates to regulatory, legal, and market changes associated with a global transition to lower carbon emissions.
Transition risks are determined by the extent to which an organisation successfully adapts to decarbonisation and manages the resulting changes in asset values. Long-term inaction amplifies risk, as changes in policy, laws, technology, and markets will pose various levels of financial and reputational risks to organisations. Alternatively, organisations that transition more rapidly can seize opportunities associated with transition, such as resource efficiency and access to new markets and financing sources [11].
For investors, transition risk emerges on the assets belonging to companies whose business clash with low-carbon economics and the regulatory landscape. 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.
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 could require banks and financial institutions to incorporate greenhouse gas (GHG) emissions into their pricing of loans and investments, with the goal of increasing the cost of borrowing for high-emitting companies [12].
Transition risk highlights how the financial system itself must evolve to survive, as well as profit, from the global shift towards sustainability. One particularly significant manifestation of transition risk is the emergence of stranded assets.
See case study 2.2.2 on how climate risk is quietly re-wiring the arteries of the global economy, which dives into how climate risks, especially within the critical minerals supply chain, are fundamentally reshaping global trade and economic stability, with a spotlight on the vital minerals driving the clean-energy transition.
Achieving the goals of the Paris Agreement and transitioning to a net-zero economy necessitates profound structural changes in the global economy, where carbon-intensive assets risk becoming obsolete or ‘stranded’. The Bank of England defines transition risk as “the risks of economic dislocation and financial losses associated with the transition to a lower carbon economy” [13].
According to a 2022 study, an estimated 60% of oil and gas reserves and 90% of known coal reserves should remain unused in order to limit global warming to 1.5°C [14].
In this scenario, we would be left with fossil fuel resources that cannot be burned and fossil fuel infrastructure (for example pipelines and power plants) that is no longer used. The global estimates of potential stranded fossil fuel assets amount to at least USD 1 trillion. [15]
The group of financial actors who face the brunt of transition risk are equity investors.
Returns dependent on capital appreciation are threatened if investee corporations fail to integrate green transition considerations in their business decision-making. Even high-performing carbon-intensive stocks are vulnerable since governments can impose carbon pricing, taxes, and cap-and-trade mechanisms, directly impacting profitability and market valuation [16].
Stranded assets are not just financial hazards but they are a call for the market to internalise climate risk and embed sustainability at the core of decision making. All of these changes in the regulatory landscape may also trigger legal scrutiny, especially for institutions perceived to be delaying transition or misrepresenting climate-related practices.
Legal risks related to climate change have become increasingly material, particularly as stakeholders seek accountability for environmental harm or greenwashing [17].
Litigation strategies are evolving rapidly. Some cases seek monetary damages based on historic contributions to climate-related harm, some aim to fundamentally change business models to better align with the goals of the Paris Agreement, and others challenge individual projects [18].
Close to 260 strategic climate lawsuits were initiated against companies from a range of sectors between 2015 and 2024 [19]. While early cases primarily targeted governments and high-emitting firms, cases against firms have proliferated quickly, and cases targeting banks and companies outside of the fossil fuel sector are no longer rare, with litigation challenging the provision of financing to companies involved in high-emitting activities on the rise [20].
In light of all these multifaceted risks, robust frameworks to measure and manage climate-related financial threats are more critical than ever.
The NGFS, a network of central banks and financial supervisors, aims to integrate climate-related risk management into the financial sector and mobilise finance for the sustainable economy transition [21]. It provides scenarios to assess climate change impacts, incorporating emission trajectories, economic growth, and energy transition policies. These scenarios are used by stakeholders, including regulators and financial institutions, to evaluate risks, conduct stress tests, and identify opportunities in renewables and green tech.
Disclosure enhances transparency and risk management by enabling market discipline. Frameworks like the Task Force on Climate-related Financial Disclosures (TCFD) and the Corporate Sustainability Reporting Directive (CSRD) guide companies on reporting climate-related risks. These initiatives ensure that firms disclose how they manage climate risks and align with sustainability objectives [22].
Established in 2015 by the Financial Stability Board, the TCFD promotes consistent and comparable climate-related financial disclosures. It focuses on governance, strategy, risk management, and metrics/targets, recommending disclosures on climate risks, opportunities, resilience to various scenarios, and greenhouse gas emissions [23]. In 2023, the TCFD’s framework was integrated into the International Sustainability Standards Board (ISSB) standards, influencing global regulatory frameworks like the UK’s [24].
The CSRD, introduced by the EU in 2021, mandates over 50,000 companies to report on ESG factors, including climate risks, using the double materiality approach. It aligns with the TCFD’s framework and the European Sustainability Reporting Standards (ESRS), requiring companies to disclose climate-related risks, transition plans, and scenario analyses. These disclosures engage all business units, from operations to the C-suite [25, 26].
Building on disclosure frameworks and acting as a stepping stone for climate-related risk management, stress testing provides a quantitative tool for assessing how financial institutions might fare under severe climate scenarios. It identifies sectors, companies, or assets that are particularly vulnerable to climate risks - whether physical (e.g., extreme weather) or transition-related (e.g., policy shifts), revealing systemic threats to financial stability.
Since the 2008–09 financial crisis, stress testing has become an essential supervisory tool to assess how financial institutions might perform under severe but plausible adverse conditions, such as economic recessions or market crashes.
In the context of climate risk, climate scenarios form the foundation of these stress tests, enabling central banks to evaluate the impact of climate-related events on bank capital, liquidity, and broader market stability. These exercises often rely on the NGFS scenarios discussed earlier to model potential financial system disruptions [27].
Climate change poses complex, far-reaching risks to the global financial system, which manifest through physical, transition, and litigation-related channels. These risks have become increasingly material for banks, insurers, institutional investors, and policymakers, influencing asset valuations, liability exposure and credit risks. The financial sector’s traditional short-term horizons are ill-equipped to address the long-term, systemic nature of the climate crisis.
Yet, the imperative is now clear; without proactive measures, climate-related risks can destabilise markets and slow sustainable economic growth.
The increasing number of market and regulatory tools populating the financial sector highlights the fact that managing climate-related financial risk is no longer a peripheral concern, but a core pillar of financial stability. As climate risk becomes a defining lens through which financial value and stability are assessed, the integration of climate resilience into financial governance is not just prudent, it is crucial. Those who grasp and act today will define the sustainable finance landscape of tomorrow.
Climate risk is a defining force reshaping the foundations of financial stability.
Physical, transitional and litigation risks expose how deeply climate change is woven into balance sheets, valuations and market confidence. The tools explored in this article signal a shift where finance should not be treated as an externality, but as a core determinant of value and resilience. Institutions which act early, embedding climate risk into strategy and governance, will both withstand disruption and help steer markets through it. Those that delay may risk being overtaken by systemic shocks that are already unfolding.
Taken together with green taxonomies, the recognition of climate risk is indeed redrawing the map of finance. Taxonomies define what credible, climate-aligned activity looks like, while risk frameworks reveal the cost of inaction and misalignment. One guides capital towards solutions, the other exposes where capital is most vulnerable. The next section builds on this foundation by examining how capital is already shifting within the global economy - towards mitigation, adaptation, and cross-cutting solutions.
The views expressed are for informational purposes only and do not constitute financial, legal, or investment advice.
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