When climate risk enters the cost of capital
Once physical climate risk influences capital allocation, it can no longer be treated as a peripheral sustainability issue. It becomes a strategic variable—one that directly affects how firms invest, finance themselves, and plan for the future.
The market signal described in the previous article is not subtle. Higher borrowing costs, tighter loan conditions, and shorter maturities all point in the same direction: exposure to physical climate risk now carries a financial premium. Once this premium exists, strategy inevitably follows.
Capital is not neutral
The cost of capital is not just a financial metric. It is a disciplining mechanism. It influences which projects go ahead, which assets are prioritised, and which business models remain viable over time.
When physical climate risk enters this equation, it does not punish companies for being unsustainable. It differentiates between those that can absorb, anticipate, or adapt to climate-related disruptions—and those that cannot.
In this sense, the market is not making a moral judgement.
It is pricing uncertainty.
This distinction matters. Climate risk does not affect all firms equally, nor does it operate uniformly across time horizons. Its strategic implications are uneven and cumulative.
Why some firms are hit harder than others
Evidence from lending markets shows that the financial impact of physical climate risk is strongest where vulnerability and exposure intersect. Two factors stand out.
First, financial condition. Firms already under financial stress experience a disproportionate increase in borrowing costs when exposed to physical climate risk. Climate exposure amplifies existing fragilities rather than creating new ones.
Second, time horizon. For short-term financing, physical climate risk has limited pricing impact. For longer maturities, it becomes material. This reflects the nature of physical risk itself: gradual, persistent, and cumulative rather than sudden and transient.
Together, these dynamics imply that climate risk reshapes strategy most strongly for firms with long investment cycles, capital-intensive assets, fixed locations, or geographically constrained operations. In these cases, physical climate exposure directly affects the feasibility and profitability of strategic choices—where to invest, for how long, and under what risk assumptions.
Operational resilience is not financial resilience
A common response to physical climate risk focuses on operational measures: asset hardening, insurance coverage, redundancy, or contingency planning. These actions matter. But they are not sufficient.
Financial resilience is a different concept. It concerns access to capital, funding flexibility, and balance-sheet capacity under stress. A firm can be operationally resilient—able to withstand climate events—and still face higher financing costs if lenders perceive elevated long-term risk.
This gap is increasingly visible in financing conditions. Markets do not assess resilience based solely on stated plans or isolated measures. They assess it through expected cash flows, volatility, and downside exposure over time. Physical climate risk enters strategy precisely at this intersection between operations and finance.
Strategy under a priced constraint
Once climate risk is reflected in the cost of capital, strategic optionality narrows. Investment decisions become more sensitive to location, asset lifespan, and capital intensity. Financing structures matter more. Capital allocation decisions carry longer shadows.
This does not mean that climate-exposed firms are destined to underperform. It means that preparedness becomes a strategic differentiator.
The market signal does not reward intent.
It rewards preparedness.
A quiet shift in strategic logic
What is changing is not the existence of climate risk, but how it is processed in decision-making. Once the cost of capital reflects physical exposure, climate risk is no longer something to be acknowledged after strategy is set.
It becomes an input into strategy itself, rather than something addressed after strategic decisions are made.
This shift is still uneven. Many organisations continue to treat physical climate risk as a reporting topic rather than a strategic constraint. But the market signal suggests that this separation is becoming harder to sustain.
Which raises the next question in the series: if markets are already pricing physical climate risk into capital decisions, why is regulation now formalising its disclosure—and what does that say about the role of frameworks such as ISSB and ESRS?
