The market has already moved: pricing physical climate risk
Physical climate risk is no longer a forward-looking concern. For a long time, it occupied an ambiguous position in corporate decision-making: acknowledged, discussed, occasionally disclosed—but rarely treated as a variable with immediate financial consequences. That ambiguity is fading.
Recent evidence from the banking market shows that physical climate risk is no longer a hypothetical future issue. It is already embedded in the price of capital. A comprehensive empirical analysis by Karol Kempa, published in the Journal of Environmental Economics and Management, examines nearly 86,000 syndicated bank loans across 77 countries and identifies a clear and robust pattern: firms exposed to higher levels of physical climate risk face systematically higher borrowing costs, across geographies, sectors, and loan structures .
On average, a one standard deviation increase in climate vulnerability is associated with an increase of roughly 40 basis points in loan spreads. This is not a marginal effect. It is economically meaningful and comparable to other well-established drivers of credit risk.
To put this into perspective, a difference of this magnitude is similar to what firms might experience when moving between adjacent credit risk categories, or when leverage metrics deteriorate in ways that materially affect lenders’ risk perception. In practical terms, it translates into higher interest expenses over the life of a loan—costs that compound over time and directly affect cash flows, valuation, and investment capacity.
Climate exposure, in this sense, is no longer an abstract externality; it behaves like a conventional financial risk factor.
From perceived risk to priced risk
The distinction matters. Perceived risk reflects expectations, narratives, or qualitative assessments. Priced risk reflects decisions—specifically, decisions taken by banks when structuring loan contracts.
This is what it means for risk to be priced: it reshapes decisions, not just disclosures.
In this case, physical climate risk is no longer confined to sustainability reports or scenario narratives. It is influencing credit conditions in real time. Higher exposure to physical climate risk is associated not only with higher spreads, but also with systematic adjustments across loan terms: shorter maturities, reduced loan amounts, stricter collateral requirements, a higher number of covenants, and increased upfront fees.
Climate risk, in other words, is reshaping the entire architecture of lending relationships.
This marks a qualitative shift. Physical climate risk is no longer mediated primarily through reputational channels or sustainability commitments. It is being processed through credit risk models, default probabilities, and loss expectations.
Why banks care—and when it matters most
The underlying mechanism is relatively straightforward. Physical climate impacts—such as floods, heatwaves, droughts, or chronic water stress—affect firms’ assets, operations, and productivity. Over time, these impacts translate into higher probabilities of financial distress and default. Banks, particularly those exposed through long-term lending, have clear incentives to anticipate these effects.
The evidence shows that this anticipation is not uniform. The pricing impact of physical climate risk is strongest for loans with longer maturities and for firms already under financial stress. For short-term lending, the effect is statistically negligible. Over longer horizons, it becomes material.
Physical climate risk is not treated as an immediate shock, but as a structural factor that erodes credit quality over time.
This also explains why financially resilient firms are less affected. Climate risk does not penalise firms indiscriminately. It amplifies existing vulnerabilities. Balance-sheet strength, adaptive capacity, and operational flexibility act as buffers—not against climate events themselves, but against how those events are translated into financial risk.
Geography, exposure, and complexity
Where and how a firm operates matters. When climate vulnerability is assessed not only at headquarters level but also across subsidiaries and operating geographies, the pricing effects become even stronger. This reflects a growing sensitivity among banks to the spatial distribution of physical risk, particularly for firms with complex or geographically dispersed operations.
The implication is not that banks have achieved precise, asset-level climate risk modelling. They have not. But even under imperfect information, the signal is strong enough to affect pricing. Banks have crossed a critical threshold: physical climate risk is now sufficiently observable, persistent, and decision-relevant to justify systematic adjustments in lending conditions.
An uncomfortable but stabilising signal
From a financial stability perspective, this development is not necessarily destabilising. Risks that are recognised and priced can be managed. Risks that remain externalised cannot.
The uncomfortable implication lies elsewhere: for many firms, exposure to physical climate risk is already translating into higher financing costs—well before regulatory disclosure requirements fully apply, and often before internal decision-making processes have adjusted.
In that sense, the market has already moved.
If physical climate risk is already influencing capital allocation decisions, it is no longer merely a reporting issue. It becomes a strategic variable—one that shapes investment horizons, resilience choices, and long-term competitiveness.
This is the question the next article in the series will explore.
