Why climate regulation is converging on physical risk
Regulation rarely moves first. More often, it arrives after markets have already signalled that something has changed.
This is also true for physical climate risk. As shown in the previous articles in this series, financial markets are already pricing exposure to physical climate impacts, and corporate strategies are beginning, unevenly, to adjust. The growing prominence of physical climate risk within both European and global sustainability frameworks should be read in this light, not as an ideological push, but as an attempt to formalise risks that have already become financially relevant.
In other words, regulation is not inventing the problem.
It is responding to it.
Why physical risk, and why now
Physical climate risk has several characteristics that make regulatory attention both inevitable and rational.
First, it is observable. Extreme weather events, chronic heat stress, water scarcity, and flooding are already affecting assets, operations, and productivity across regions and sectors.
Second, it is cumulative. Physical climate risk unfolds over time, interacting with asset lifetimes, investment horizons, and capital intensity. Its financial relevance increases precisely where long-term strategic commitments are highest.
Third, it is structurally uncertain. Physical climate risk does not lend itself to easy diversification or short-term mitigation. It introduces persistent uncertainty into cash flows, asset values, and business continuity.
Together, these characteristics explain why physical climate risk can no longer remain outside regulatory frameworks focused on financial relevance.
From market signal to regulatory architecture
Climate regulation is not designed to predict impacts with precision. Its underlying logic is different.
Standards such as ESRS and IFRS seek to create shared structures for identifying financially material sustainability risks, assessing the time horizons over which they unfold, and evaluating the resilience of business models under plausible future conditions.
This mirrors the way markets already process physical climate risk, not as a binary issue, but as a factor shaping risk profiles, capital costs, and long-term viability. The emphasis on resilience, scenario analysis, and forward-looking information reflects the limits of historical data in capturing these dynamics.
This is not about expanding disclosure for its own sake.
It is about aligning reported information with the risks that already influence financial decisions.
The convergence problem
Despite this alignment in intent, a gap remains.
Markets price risk through spreads and contractual terms. Strategy responds through investment choices and capital allocation. Regulation relies on structured disclosure to make risks visible and comparable.
ESRS and IFRS can be understood as translation mechanisms between these domains. They seek to convert dispersed market signals and firm-specific exposures into decision-useful information that can travel across organisations, investors, and supervisors.
They seek to convert dispersed market signals and firm-specific exposures into decision-useful information that supports governance, comparability, and capital allocation.
This explains why these standards emphasise financial materiality, time horizons, and resilience rather than generic sustainability narratives. The objective is not to moralise corporate behaviour, but to reduce blind spots in how risk is identified, assessed, and governed.
Where the technical frameworks come in
At this point, the role of regulation becomes clearer.
Standards do not ask companies to report physical climate risk because it is fashionable or politically salient. They ask because physical climate risk has demonstrated its capacity to affect financial performance, cash flows, access to finance, and the cost of capital.
This is where the technical architecture of ESRS and IFRS matters, how materiality is defined, how time horizons are structured, how scenario analysis is used, and how resilience is framed.
From a strategic perspective, this matters because these design choices determine whether climate risk information remains peripheral, or becomes integrated into core decision-making.
How ESRS captures physical climate risk in practice
From a regulatory perspective, ESRS formalises physical climate risk once it meets a simple condition, financial relevance.
At its core, the standard is built around double materiality, explicitly linking sustainability-related impacts with financial risks and opportunities. Physical climate risk enters ESRS not because of its environmental significance alone, but because of its demonstrated ability to affect financial outcomes.
Financial materiality as the entry point
Under ESRS, a sustainability issue becomes financially material when it affects, or can reasonably be expected to affect, financial performance, financial position, cash flows, access to finance, or cost of capital.
From a strategic perspective, this matters because once physical climate risk influences lending conditions or capital allocation, it can no longer be managed outside mainstream financial decision-making.
Time horizons and cumulative risk
Physical climate risk unfolds over time, often beyond traditional financial planning cycles. ESRS explicitly addresses this by requiring companies to assess material risks across short, medium, and long-term horizons.
For organisations with long-lived assets or geographically fixed operations, this requirement forces visibility of risks that may appear immaterial in the short term but become decisive over asset lifetimes.
Resilience, not prediction
ESRS does not expect companies to predict future climate outcomes. Its focus is on resilience, whether a company’s strategy and business model remain viable under plausible physical climate risk scenarios.
From a strategic standpoint, this shifts the conversation from forecasting impacts to testing robustness under uncertainty.
Beyond historical data
Physical climate risk exposes the limits of backward-looking analysis. Historical data alone cannot capture future climate dynamics.
ESRS therefore requires the use of reasonable and supportable forward-looking information, even where uncertainty is high. Judgement is not a flaw in the framework, but a necessity given the nature of the risk.
ESRS as a translation mechanism
Taken together, these elements clarify the role ESRS plays in the broader system.
Markets signal risk through pricing. Strategy responds through decisions. ESRS translates these signals into structured, comparable information that can inform governance, oversight, and capital allocation.
How IFRS S1 and S2 capture physical climate risk
While ESRS provides the European regulatory articulation of physical climate risk, the IFRS Sustainability Disclosure Standards reflect the same underlying logic from an investor-focused perspective.
IFRS S1 and IFRS S2 frame physical climate risk as a financially relevant source of uncertainty, one that can affect enterprise value through cash flows, asset values, and the cost and availability of capital.
Financial relevance as the entry point
Under IFRS, sustainability-related risks fall within scope when they could reasonably be expected to affect an entity’s prospects.
This aligns directly with the logic developed earlier in the series. Once physical climate risk affects cash flow expectations or capital pricing, it becomes decision-useful for capital providers.
Observable, cumulative, and structurally uncertain risk
IFRS S2 explicitly defines physical climate risk as arising from both acute events and chronic shifts in climate patterns, and links these directly to financial implications.
IFRS S1 reinforces the need to assess these risks across short, medium, and long-term horizons, consistent with strategic planning timeframes.
Resilience, not precise prediction
IFRS requires disclosure of the resilience of strategy and business model to sustainability-related risks. Climate-related scenario analysis is used to test robustness under plausible future conditions, not to generate precise forecasts.
Forward-looking information and uncertainty
IFRS explicitly requires disclosure of anticipated financial effects using reasonable and supportable information. At the same time, it recognises estimation uncertainty as normal, provided assumptions and limitations are transparently explained.
Quantification and connected information
IFRS S2 requires quantitative disclosure of exposure to physical climate risk, including the amount and percentage of assets or activities that are vulnerable.
IFRS S1 further requires connected information, linking sustainability disclosures with financial statements, reinforcing the translation of risk into financial context.
Regulatory anchors
For readers seeking regulatory traceability, the references below link the article’s arguments to specific ESRS and IFRS provisions.
ESRS
ESRS 1, General Requirements, paragraphs 2 and 15(b)
ESRS E1, Climate Change, paragraphs 6–7
ESRS 1, Time horizons, section 6.2
ESRS E1-3, Resilience in relation to climate change
ESRS E1-2, Identification of climate-related risks and scenario analysis
ESRS 1, Chapter 7.2, Judgement and uncertainty
ESRS E1-11, Anticipated financial effects from physical and transition risks
ESRS 2, SBM-3, Interaction of impacts, risks and opportunities with strategy
IFRS
IFRS S1, paragraphs 1, 21(b)(ii), 30(b)-(c), 36(a), 41, 79
IFRS S2, paragraph 2, paragraph 29(c), Appendix A, Appendix B (B1), paragraphs B64–B65
Closing reflection
The unresolved challenge is no longer whether physical climate risk should be disclosed.
It is whether organisations are equipped to govern it, translate it into capital allocation decisions, and act on it before disclosure becomes a post-hoc exercise.
That governance gap is the focus of the final article in this series.
