Untangling Climate Risk, Financial Risk, And Climate Impact

“Climate risk is financial risk” is an increasingly ubiquitous incantation. It is frequently invoked in discussions about shareholder proposals, the need for companies to adopt transition plans (which I have discussed before), asset managers’ engagement with portfolio companies, and banks’ financing of fossil fuels, to name a few topics.

The problem is that this incantation is often used to conflate climate impact with financial risk, with the assumption that emissions equate to financial risk and that managing climate-related financial risk will deliver net-zero outcomes. While climate risk certainly can pose financial risk, climate risk is not always financial risk, and managing the financial risk from climate change is not the same thing as managing climate impact. Impact can be high even when financial risk is low.

Moreover, characterizing what are really calls for emissions reduction as calls to address financial risk has now politicized the discussion about what needs to be done to create a net-zero world and may now doing more harm than good. Unless we are able to untangle the conflation of climate risk, financial risk, and climate impact we will see continued politicization of climate risk founded in a misplaced reliance on the financial sector to drive the energy transition.

Consider the reaction to BlackRock, J.P. Morgan Asset Management, and State Street Global Advisors withdrawing from Climate Action 100+. Cries of outrage claiming that this was a setback for the climate agenda were met by cheers that these investors were backing off of a progressive “woke” agenda. In fact, neither is true. Asset managers are fiduciaries. Their engagement with portfolio companies has always been about risk-adjusted returns, in line with the stated aims of the investment strategies they manage. But the source of the controversy clearly has nothing to do with financial risk. The controversy is because both camps have conflated asset managers’ engagement on risk-adjusted returns with engagement on climate impact, and mistakenly assume that asset managers have the ability to drive the economy to decarbonize faster. The criticism from both sides reflects just how far the narrative has slipped away from reality.

Another example is the rhetoric around bank financing of fossil fuel companies. Calls for banks to stop financing fossil fuels are commonly framed as calls for banks to manage financial risk when it’s clear that the underlying objective often has little to do with genuine concern for the safety and soundness of banks. Moreover, hand-waving that equates financed emissions with financial risk to banks conveniently ignores the short time horizon of most corporate lending. A bank doesn’t have 10-year credit risk on a one-year loan—and no one thinks “big oil” is going bankrupt in the immediate future. Unfortunately, bank financing of oil and gas has now been effectively politicized, in turn provoking backlash from Republicans concerned that banks will starve oil and gas companies of capital and harm U.S. energy security. Again, the controversy has nothing to do with actual financial risk. It’s based on the assumption, on the one hand, that banks can and should drive the transition through capital reallocation, and, on the other hand, concerns that banks are being pressured into playing a government role in actively shaping energy and industrial policy.

At a system level, we see this happening with central banks. Their independence is being questioned as they are fending off calls to manage climate-related financial risk by using banking regulation to cut off financing for fossil fuels, while simultaneously facing accusations that their focus on climate-related financial risk is a thinly veiled effort to drive climate policy. Senior ECB personnel have been criticized for using banking regulation as a lever to drive climate policy through banks, and the Federal Reserve has had to emphasize over and over that its efforts to address climate-related financial risk are solely financially risk-focused.

But what do we really mean when we’re talking about climate-related financial risk? Going back to basics, when we talk about financial risk, what we’re talking about is risk of financial loss. Then the next question is risk of financial loss to whom? Over what time horizon? And how material is that risk of financial loss? These are important questions. Sometimes they are implicitly assumed, but often too vaguely stated and sometimes not at all.

Let’s take the example of a hypothetical oil and gas company we’ll call Carboniferous, Inc. It’s a commonly cited statement that oil and gas companies are subject to high transition risk. This is shorthand for the view that Carboniferous, Inc. will become less profitable over time and may even go out of business as the transition progresses, leaving it with billions of dollars in stranded assets which have no value at all.

But transition risk posed to Carboniferous’s business over time does not necessarily neatly translate into material financial risk to Carboniferous’s investors. Investors should be concerned if Carboniferous does not have a proper strategy that takes account of the impact the energy transition will have on the company. At the same time, investors should acknowledge the reality that demand for fossil fuels may persist for longer than many would like due, at least in part, to lack of government policies, such as a carbon tax. Which I strongly support. But the financial risk of an investment in Carboniferous will ultimately depend on the investor’s time horizon and the size and diversification of its overall portfolio, as well as any hedging mechanisms it has in place. An investor may determine that the financial risk is low, and the financial reward is high given Carboniferous’s current profitability.

Does Carboniferous’s transition risk create financial risk for a bank that finances it? That depends on the financing instrument and its time horizon, any risk mitigants or hedges the bank has in place, and the overall diversification of the bank’s portfolio. The bank’s financial risk exposure to Carboniferous is the risk that Carboniferous will not repay the loan. Many banks’ lending books consist of loans with terms of one to five years. If Carboniferous is highly profitable with a strong balance sheet, the probability of default or impairment over that time horizon may be very small. Furthermore, the bank will price any perceived risk of default into the cost of the financing. Even if Carboniferous defaults, there’s the further question of whether this creates any material risk for the bank. A regional bank that has a significant oil and gas portfolio may have more risk than a large global diversified bank where oil and gas loans are a tiny percentage of its overall business.

Notably, the public conversation on transition risk almost exclusively focuses on the risk that a company is not transitioning fast enough—equating emissions with financial risk. As one example, a commonly cited transition risk is the risk that a company is not aligned with government commitments to net zero in the countries where it does business and will be negatively impacted as those governments implement new policy to meet their net zero commitments.

However, there is much less discussion about the risk from transitioning too quickly. For example, an auto manufacturing company that invests in an electric vehicle manufacturing plant in reliance on stated government plans to phase out ICE vehicles could be hurt if the government delays its plans due to voter pressure, thereby creating financial risk for its investors.

I can think of no other topic where we insist that companies are exposed to financial risk if they do not make significant business decisions on blind faith that governments will deliver on their stated long-term policy goals. It is also worth questioning whether governments will have the political support to impose policy that will bankrupt key sectors on which their economies are still highly dependent. Transition risk due to shifts in government policy is clearly not as straightforward as it is often made out to be, and we can’t use calls to manage transition risk as a proxy for driving net zero outcomes. Achieving net zero will be challenging and complex, with financial risks in all directions, and navigating those risks may not neatly align with net-zero progress.

Somewhat bafflingly, the “climate risk is financial risk” discussion has had very little focus to date on the risk of second-order effects of climate change. A major climate-driven economic downturn and a decrease in global GDP could pose much greater financial risk to asset prices than the climate itself. As one example, a severe drought that catalyzes mass migration and destabilizes other regions’ economies can cause a major global macroeconomic disruption. As another example, a disorderly transition that creates significant increases in energy and commodity prices would have significant macroeconomic implications for businesses more broadly. In these cases, climate-related financial risk isn’t necessarily stemming from exposure to high-emitting companies; much broader swaths of the economy are affected and what will matter is a company or financial institution’s general resilience to a major economic downturn.

It's especially disconcerting to see the lack of much discussion by central banks about second-order effects. Failure to recognize this can lead to well-intended but ineffective policies, or even make things worse. Increasing capital requirements, say, for banks doing lending to high-emitting sectors, is sometimes advocated as a potential tool to decrease emissions and reduce financial risk from climate change. This assumes, however, that: (1) increasing the cost of capital for high-emitting sectors will reduce financial risk and (2) central bankers are equipped to set energy policy without creating more risk to the global economy (including eroding central bank independence).

While central bankers cannot solve climate change, they are very well-positioned to drive research on second-order effects and shine a light on the potential ramifications of broader macroeconomic disruptions driven by climate change. I don’t have a clear view on what this research should be and what can be done based on it, but for people genuinely focused on risk, that should be scarier than financial risk from investments in and finance to oil and gas companies.

Climate risk can certainly create financial risk. But the specifics matter and it’s important to be clear about magnitude, likelihood, and time frames. We need a more intellectually robust conversation that recognizes that climate impact does not neatly equate to financial risk and that calling for companies and financial institutions to manage their own climate-related financial risk will not deliver net zero. Conflating climate impact with financial risk undermines the intellectual credibility of the important work needed to understand how climate change will transmit into financial risk for various actors in the economy. Most importantly, framing climate-related financial risk as a tool to deliver net-zero outcomes not only politicizes efforts to manage financial risk, but it also holds us back from having an honest conversation about what is actually needed to deliver net-zero outcomes.