TL;DR
- Traditional risk models are inadequate for assessing climate risks and opportunities, highlighting the need for climate-adjusted financial models in pricing climate risk in sustainable finance.
- Climate data should be incorporated into lending to enable accurate pricing and informed investment decision-making.
- Specialised tools (including climate-adjusted financial models, climate data analytics platforms, and scenario analysis models) can support you in effectively managing climate risks and opportunities.
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Duration: 17 minutes
While sustainable finance is a growing avenue for responsible investment decision-making, escalating climate risks and limited risk mitigation remain concerns for the performance of financial instruments. The main issue?
In pricing climate risk in sustainable finance, many lenders and asset managers continue to rely on traditional risk models, which often fall short in reducing the uncertainties associated with climate risks.
Suppose your goal is to ensure that every asset and loan is priced accurately in light of future exposure. In that case, this article offers practical recommendations and illustrative examples to help you achieve that objective.
The Problem with Traditional Risk Models
Lenders and portfolio managers are increasingly incorporating climate risk models in pricing climate risk in sustainable finance.
However, traditional models often fail to capture the complexities of climate-related risks, frequently mispricing potential threats due to reliance on outdated data.
Lukky Ahmed, CEO and co-founder of Climate X, when interviewed by the BBC, stated: “We can no longer rely on historical data,” adding that “a lot of firms are relying on outdated catastrophe models.
They're just not fit for purpose in a climate-changed world.”
Last year, research conducted by a group of financial experts revealed that approximately 70% of financial institutions underestimated investor losses stemming from physical climate risks.
This suggests that if you have not yet integrated forward-looking climate risk models into your portfolios, you may be exposed to significant financial losses.
Similarly, Robert Engle, co-director of the Volatility and Risk Institute at NYU and Nobel laureate, warns: “Without robust risk assessment, there is a danger of either overestimating or underestimating the consequences of climate change, leading to inefficient policies or market instability, which in turn can impact investors and companies.”
As a lender or portfolio manager, you may encounter the following issues with traditional risk models:
- Inadequate consideration of climate-related risks, as many risk types may fall outside the scope of your current assessments.
- Insufficient data and lack of granularity — among the most common challenges.
- Inability to capture the non-linear relationships between climate risks and financial performance.
- Failure to account for systemic risks and tipping points.
- Inadequate stress testing and scenario analysis.
We can no longer rely on historical data. A lot of firms are relying on outdated catastrophe models, but they're just not fit for purpose in a climate-changed world."
Lukky Ahmed, CEO of Climate X
Climate Data in Valuation & Pricing
Climate valuation and the pricing of climate risk in sustainable finance are distinct concepts that warrant careful consideration in sustainable finance.
For lenders or asset managers like yourself, understanding the difference between the two is essential for making informed investment decisions.
Climate valuation refers to the assessment of the financial impact of climate-related risks on assets and portfolios.
In contrast, within sustainable finance pricing climate risk means incorporating climate-related data into financial models to accurately value loans and securities.
Lukky also observes: “Asset managers want climate data, but also want to know how it affects portfolio allocation, but that translation layer is still missing in most tools”.
Here is how you can approach climate data for lending in the context of lending:
- Collect and integrate climate-related data into your financial models.
- Consider partnering with climate data providers and utilising analytics platforms to strengthen your data capabilities.
- Develop a robust climate risk assessment framework to guide your lending and investment decisions.
- Leverage climate data to identify opportunities in adaptation finance, such as resilience-linked products and climate adaptation lending
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From Asset-Level Exposure to Price Modelling
It is worth noting that physical climate risks can impact borrowers through increased costs, reduced revenues, or declining property values, potentially leading to higher loan-to-value (LTV) ratios and increased default risk.
In this context, conducting asset-level assessments to identify the most at-risk assets is a critical step towards accurate price modelling.
Focusing on the specific vulnerabilities within your assets and portfolios is essential for making informed decisions and developing targeted strategies to manage climate-related risks and capitalise on emerging opportunities.
In the EU, banks were expected to fully integrate climate-related and environmental (C&E) risk factors into their loan price modelling by the end of 2023, and to meet all other ECB expectations for C&E risk integration by 2024.
To date, not all supervised banks have complied with these expectations. This indicates that many lenders are still unprepared to move from identifying physical climate risks at the asset level to implementing effective pricing models.
Ahmed explains: “Data availability is one thing, but the real issue is interpreting it in a way that makes sense for financial decisions.
Most organisations aren't equipped for that.” This highlights the need for specialist expertise and advanced analytics tools, such as Climate X’s services and products, to help you translate climate data into effective pricing decisions.
This approach can involve:
- Assessing asset-level vulnerabilities – Identify climate-related risks and opportunities affecting individual assets.
- Quantifying climate impacts – Use climate-adjusted financial models to estimate the potential effects on asset values and performance.
- Testing resilience, monitoring, and refining – Explore multiple climate scenarios and stress test your models to ensure robustness. Use climate data and analytics to continuously monitor and update your price modelling over time.
- Integrating with existing systems – Incorporate climate risk assessments seamlessly into your existing risk management systems and processes.
Climate Risk-Adjusted Modelling & Securities Pricing Tools
Climate risk-adjusted modelling requires specialised tools and techniques to accurately reflect the complexities of climate-related risks.
Lenders who adopt the right tools can refine their existing price modelling and avoid unforeseen losses linked to climate risks.
Advanced climate-adjusted financial models can also help identify opportunities for resilience-linked products and climate adaptation lending.
However, implementing such models may come with challenges, particularly around data limitations and model complexity.
These tools include:
- Climate risk-adjusted modelling, such as Climate-Adjusted Capital Requirements (CACRs), which require banks to set aside additional capital for loans exposed to climate risks.
This makes such loans more costly and incentivises reduced investment in vulnerable assets.
- Climate data providers and analytics platforms, like Climate X’s Spectra, which offers asset-level assessments and climate risk modelling capabilities.
Ahmed highlights: “While many climate models might tell you how much rainfall to expect, they don’t say what happens when that water hits the ground. [...] Our models simulate, for example, what happens when the water hits, where it travels, and what the impact of the flooding will be.”
- Climate risk assessment frameworks and guidelines, such as the ISSB’s IFRS S2 recommendations.
- Scenario analysis and stress testing tools, which help evaluate the potential impact of different climate scenarios on your assets and portfolios.
For example, the Bank of England’s 2022 Climate Biennial Exploratory Scenario (CBES) projected that climate-related credit losses for UK banks could double — reaching an additional £110 billion over a 30-year period under a late action scenario.
Examples of Risk-Based Pricing in Action
Climate risk-based pricing is becoming increasingly important in sustainable finance, as investors and asset managers aim to integrate climate-related risks into their investment decisions.
Current trends in climate risk-based pricing are highly relevant, as they can help you reassess your own climate risk management strategy — including pricing, climate adaptation lending practices, and resilience-linked products.
Here are some examples:
- The Organisation for Economic Co-operation and Development (OECD) climate-resilient infrastructure financing programmes, which use climate-adjusted financial models to assess the climate resilience of infrastructure projects.
By factoring in climate-related risks, the OECD can set interest rates or investment terms that reflect the true level of risk, thereby encouraging more resilient infrastructure development.
- The International Finance Corporation (IFC)-UniCredit Joint Green Bond initiative, a €108 million investment in Romania to provide green loans for SMEs and green housing loans.
Resilience bonds not only limit investment risk for investors upon completion of a funded project but also contribute to building resilient infrastructure, ensuring long-term returns.
- The Climate Resilient Development Bond (CRD Bond), which links risk transfer with resilience through the use of institutional investor funding, minimising the impact of potential climate-related shocks.
Pricing climate risk in sustainable finance requires moving beyond traditional risk models and embracing climate risk-based pricing that accurately reflects the realities your assets and portfolios face.
To achieve this, you should consider leveraging climate-adjusted financial models, data-driven decision-making, and specialised tools such as climate data analytics platforms.
The solutions are within reach, and the examples of risk-based pricing in action highlight the growing importance of this approach.
Now is the time to take the next step, if you haven’t already: integrate these strategies into your lending and investment decisions to ensure that every asset and loan is priced appropriately against future exposure. Watch our webinar below to discover our suggested approach.
The only question left is: what is holding you back from embracing a more sustainable and resilient financial future?
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