While climate finance often emphasizes transition risk, the critical importance of physical climate risk should be highlighted as it may have an even greater impact on financial markets, writes EDHEC Climate Institute.
Research shows how physical damage impacts equity valuations under different policy and climate scenarios, revealing potential market mispricing. It underscores the need to better incorporate physical risks into financial models, as current valuations may miss their true economic effects.
Climate risk assessments often use separate scenarios that focus on extreme transition risk or severe physical risk, neglecting the probabilistic interplay between these outcomes.
There are proposed methods to attach probabilities of various emission abatement scenarios, integrating technological, fiscal, and policy feasibility into the analysis. One article highlights a low probability of achieving the Paris Agreement target and the need for a more realistic alignment between economic recommendations and policy action.
EU leadership
The EU has an opportunity to lead by example by creating a sustainable finance framework that balances ambition with practicality.
By integrating transition finance into its broader strategy and leveraging science-based tools, robust reporting systems, and clearly defined product categories and labels, the EU can set a global standard for channeling financial flows toward systemic decarbonization. Achieving this will not only support the bloc’s climate goals but also provide a blueprint for global action against climate change.
For jurisdictions favoring principle-based approaches, the EU framework offers important lessons. Granting excessive leeway to product providers can undermine transparency and effectiveness. And while granular criteria bring clarity and accountability, they require extensive taxonomy work with lead times that may delay urgent climate action.
Principle-based frameworks, by contrast, can foster flexibility and innovation, enabling firms to tailor their strategies to local and sectoral contexts while reducing compliance burdens. However, this flexibility must insist on science-based pathways, criteria, and metrics, and be paired with robust governance and accountability mechanisms to mitigate greenwashing risks and ensure alignment with sustainability goals.
By fostering public-private collaboration, embracing evidence-based classification of transition activities and investments, and promoting transparent reporting of decision-relevant metrics, all jurisdictions can design effective frameworks that support investor choice and direct financial flows toward the transition at scale.