Climate Risk: Who Prices it and How?

Written by: Owen Casey

Edited by: Ashley Yeung

Junior Division

Once just the worry of scientists and policymakers, climate change has evolved into a material concern for investors trying to assess its financial implications. As a result, the concept of climate risk, in a financial context, has developed clear theoretical and operational definitions. Since its origins, climate risk has been embraced as an effective mechanism in lowering carbon dioxide emissions by encouraging firms to “de-risk” their businesses by becoming less carbon-intensive. While the theoretical logic of climate risk is sound, its practical implementation by investors is often incomplete. As the evidence will show, climate risk has had a substantive impact on many debt investments, yet the degree to which it is fully priced into equity investments is debated. An analysis of how investors actually price climate risk brings forth important conclusions about its capacity to drive emissions reductions. After first outlining the primary categories of climate risk, this article will examine how equity and debt investors price them, before considering how climate risk can effectively help to lower emissions.

Main Types of Climate Risk

There are three overarching types of climate risk: physical, transition, and liability. Physical risks can be plainly thought of as “...those risks that arise from the physical impacts of climate change” (University of Cambridge Institute for Sustainability Leadership, 2025, p. 9). The physical impacts of climate change stem from the various extreme weather events which climate change renders more severe and frequent. This broad definition of physical risks can be further distinguished between acute risks and chronic risks. Acute risks arise from singular events such as hurricanes, floods, or hailstorms. Alternatively, chronic risks are spurred by longer-term changes in the climate. For example, all of the harmful changes that result from a higher global average temperature or rising sea levels. Both acute and chronic physical risk threaten asset value, business operations, and other material factors that investors consider. (University of Cambridge Institute for Sustainability Leadership, 2025)

Transition risks are derived from the structural changes in the economy that arise due to climate change; in other words, they are “...the costs of economic dislocation and financial losses associated with the process of adjusting toward a low-carbon economy” (Campiglio et al., 2019, p. 4). There are three primary sources of transition risk: changes in policy, changes in technology, and changes in market preferences (Campiglio et al., 2019). Changes in policy can introduce new regulations (e.g., carbon taxes) or impose new incentives for low-carbon businesses (e.g., clean energy tax credits). Next, changes in technology bring about low-carbon alternatives to carbon-intensive products, services, and processes, increasing efficiency and cost-effectiveness. Finally, there are changes in market preferences driven by a desire to lower emissions. These changes in preference reduce demand for products and services reliant on high carbon outputs while increasing demand for low-carbon alternatives. These three forms of transition risk all pose serious potential harm to firms that fail to adapt to a low-carbon world.

The last type of climate risk is liability risk. In general, liability risk is “...the possibility that legal action will be taken because of an individual’s or corporation’s actions, inaction, products, services, or other events” (Investopedia, 2025). Climate liability risk specifically refers to the liability stemming from climate litigation. The Sabin Center for Climate Change Law (2025) understands climate litigation to be all judicial and quasi-judicial cases where climate change law, policy, or science is a material issue. Such climate litigation is considered a financial risk because if liability is established, then financial compensation to other parties may be required.

Do Investors Price Climate Risk?

Before analyzing whether investors actually consider climate risk, it is useful to understand how equity and debt are valued in general. For both equity and debt securities, valuation is grounded in their future payoffs and risk premiums. Future payoffs refer to the cash that investors expect a security to generate over its lifetime through dividends, interest payments, and principal repayments. The risk premium is a value calculated on a range of different variables. However, the general principle is that the riskier an asset is, the higher its risk premium and cost of capital will be. A higher cost of capital means that investors will demand a higher rate of return to invest in the security. A demand for higher returns is reflected in an asset having a lower price relative to its less risky counterparts. Hence, if climate risk is priced in, then assets with higher climate risk exposure would be cheaper and have a higher expected rate of return. As I will show, the extent to which investors have priced climate risk has differed between equity and debt investments.

Research has revealed that debt investors diligently price climate risk. One way through which researchers have studied this is by analyzing credit yield spreads and credit ratings. Credit yield spreads measure the difference in yields between a low-risk bond and a higher-risk bond of the same maturity. The bigger the difference between the two yields, the larger the spread, which indicates a higher degree of risk. Hence, yield spreads are used to “...ascertain how much an investor would be compensated for taking certain risks” (CFA Institute, 2026). Credit ratings are “...forward-looking opinions about an issuer’s relative creditworthiness” (S&P Global, 2026). The ratings are produced by designated rating agencies and provide a universal standard for investors to use in assessing how likely a debt issuer is to default. A study by Lee Seltzer et al. (2025) specifically studied the effects of climate regulation exposure (a transition risk) on corporations’ credit ratings and credit yield spreads. They found that firms that have higher carbon emissions and intensities (and therefore higher regulatory risk) have higher credit yield spreads and lower credit ratings, thus reflecting that investors are pricing climate transition risk.

Another study of climate risk and corporate bonds, conducted by Elsa Allman (2022), focuses on physical risk - specifically, sea level rise. Using credit yield spread and credit ratings to measure whether climate risk is being priced, she found that sea level rise exposure had a significant effect on increasing credit yield spreads but no effect on credit ratings. Her findings corroborate the view that debt investors do price climate risk, albeit not as strongly as Seltzer et al. Finally, Ugolini et al. (2023) researched the pricing of transition risk through analyzing credit default swap (CDS) spreads. CDS’s are insurance policies that lenders can buy, in which they pay another party to financially protect them in the event that the bond issuer defaults. The spread is what the issuer pays the seller of the CDS to provide the protection, meaning that a higher spread indicates that investors believe there is a higher chance of default (Köseoğlu, 2019). The authors developed their own climate transition risk measure and found that lenders to firms with high (as opposed to average) transition risk experience higher CDS spreads. Taken together, research has shown that debt investors have been attentive to climate risk, consistently incorporating both physical and transition risk into investment calculations.

The pricing of climate risk by equity investors, on the other hand, has proven to be ambivalent. Researchers have offered conflicting conclusions, with their contention largely centering on whether a ‘carbon risk premium’ exists. A carbon risk premium is simply the idea that investors demand a higher return (a premium) from companies that are more vulnerable to climate risk (Campiglio et al., 2019). This is manifested through companies with higher exposure to climate risk having lower stock prices and higher expected rates of return. One of the foremost pieces of research that backs the existence of a carbon risk premium was conducted by Bolton and Kacperczyk (2021). They matched firms’ carbon emissions with their stock returns, and found that firms with higher total emissions and greater growth in emissions had significantly higher returns. Another important endorsement of the existence of a carbon risk premium came from Hengge et al. (2023), who researched the effect of climate policy on stock returns. They found that surprise policies, which were expected to raise the EU’s carbon price, depressed the returns of carbon-intensive stocks. This increases the perceived risk held by investors, who in turn demand a greater premium, leading more carbon-intensive firms to carry higher expected long-run returns, clearly indicating the presence of a carbon risk premium. On the other hand, an important piece of research (Bauer et al., 2022) that sheds doubt on the existence of a carbon risk premium examines the stock performance of ‘green’ versus ‘brown’ portfolios from 2010 to 2021, finding that green portfolios consistently outperformed brown ones. A similar study (Loyson et al., 2023) focused on Europe found that, from 2005 to 2019, there was no positive correlation between carbon emissions and stock returns. Such findings reveal persistent inconsistencies between the expected and actual returns of carbon-intensive and low-carbon companies, suggesting that equity markets have yet to price climate risk in a coherent or systematic way.

Should Financial Markets be Considered a Green Solution?

The incorporation of climate risk among investors has been considered a potential mechanism by which financial markets can act as a catalyst in lowering carbon emissions. The logic of climate risk suggests that firms with high carbon emissions should face a higher cost of capital, which would make it harder to attract investors and expand business, thereby incentivizing a transition towards low-carbon activity. However, the degree to which climate risk is priced by investors in practice remains uncertain, at least in equity markets. Even if one accepts the existence of a carbon risk premium, ample capital continues to flow to carbon-intensive companies, as investors remain willing to bear the risk in exchange for a higher expected return. Hence, the market seems to struggle to cultivate a climate risk premium that meaningfully disincentivizes brown investment.

However, this shortcoming is more indicative of a policy failure than a fundamental limitation of financial markets. Investors respond to risk when they are confident it exists and when there are clear means by which to hedge it. Given the long time horizons over which many climate impacts materialize, effective hedging instruments remain limited (Eren et al., 2022). Moreover, investors have had to contend with persistent uncertainty over the trajectory of climate policy, which has complicated the pricing of transition risk (Eren et al., 2022). As then Bank of England Governor Mark Carney argued in his 2015 speech Breaking the Tragedy of the Horizon, “...a market in the transition to a two-degree world can be constructed and has the potential to pull forward adjustment - but only…if the policy responses of governments are credible” (Carney, 2015, p. 12). So, while financial markets could do more to advance the green transition, the primary onus falls on policymakers to provide the regulatory clarity and long-term commitment that would allow climate risk to be priced with the force that the transition demands.

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References

Allman, E. (2022) Pricing Climate Change Risk in Corporate Bonds. Journal of Asset Management, 23(7), 596-618.

Bauer, M.D., Huber, D., Rudebusch, G.D., and Wilms, O. (2022) Where is the carbon premium? Global performance of green and brown stocks. Journal of Climate Finance, 1.

Bolton, P., and Kacperczyk, M. (2021) Do investors care about carbon risk?. Journal of Financial Economics, 142(2), 517-549.

Campiglio, E., Monin, P. and Von Jagow, A. (2019) Climate Risks in Financial Assets. Council on Economic Policies, November, p. 4.

Carney, M. (2015) Breaking the Tragedy of the Horizons - climate change and financial stability. [Online]. Available from: https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.pdf.

CFA Institute (2026) Yield and Yield Spread Measures for Fixed-Rate Bonds. [Online]. Available from: https://www.cfainstitute.org/insights/professional-learning/refresher-readings/2026/yield-and-yield-spread-measures-for-fixed-rate-bonds.

Eren, E., Merten, F., Verhoeven, N. (2022) Pricing of climate risks in financial markets: a summary of the literature. BIS Papers, No. 130, 1-11.

Hengge, M., Panzzia, U., and Varghese, R. (2023) Carbon Policy and Stock Returns: Signals from Financial Markets. IMF Working Paper, No. WP/23/13, 1-34.

Investopedia (2025) Understanding Litigation Risk: Key Definitions and Examples. [Online]. Available from: https://www.investopedia.com/terms/l/litigation-risk.asp.

Köseoğlu, S.D. (2019) Valuation Challenges and Solutions in Contemporary Business. Hershey, PA: Business Science Reference.

Loyson, P., Luijendijk, R., and Van Wijnbergen, S. (2023) The pricing of climate transition risk in Europe’s equity market. DNB Working Paper, No. 788, 1-60.

Sabin Center for Climate Change Law (2025) Climate Litigation Database. [Online]. Available from: https://www.climatecasechart.com/methodology.

Seltzer, L.H., Starks, H. and Zhu, Q. (2025) Climate Regulatory Risk and Corporate Bonds. NBER Working Paper Series, 1-68.

S & P Global (2026) What is a Credit Rating?. [Online]. Available from: https://www.spglobal.com/ratings/en/credit-ratings/about/understanding-credit-ratings.

Ugolini, A., Reboredo, J.C., Ojea-Ferreiro, J. (2023) Is climate transition risk priced into corporate credit risk? Evidence from credit default swaps. Center for European Studies Paper Series, No. 509, 1-36.

University of Cambridge Institute for Sustainability Leadership (CISL) (2025) Investing in Tomorrow: A Guide to Building Climate-Resilient Investment Portfolios. Cambridge, UK: Cambridge Institute for Sustainability Leadership.