How Does Climate Risk Affect Cost of Capital?

Firms with high exposure to physical climate hazards are encountering a tangible rise in their cost of capital, with new data suggesting markets are actively pricing this risk into corporate finance. This trend is particularly pronounced in emerging markets and for businesses in asset-heavy industries.

For years, the financial services and insurance sectors have charged premiums to clients exposed to various risks.

With the escalating effects of climate change, these premiums are expanding beyond insurance policies and are now visibly affecting the cost of capital.

Analysis from Bloomberg quantifies how global markets are pricing environmental threats into corporate financing, indicating a systematic penalty for businesses exposed to climate risk.

The research shows that for every 10 percentage point increase in potential asset damage from climate hazards, companies face an additional 22 basis points in their average cost of capital. This premium is present even after accounting for factors like sector, region and company size.

"In other words: if you’re more exposed to storms, floods, or heatwaves, financing gets more expensive – and valuations take a hit," explains Niall Smith, Senior Sustainable Investments Quantitative Researcher at Bloomberg, who was the leader of the study.

Quantifying climate risk in finance

The findings from Bloomberg offer one of the first detailed efforts to measure if physical climate risk, as separate from transition risk, has a discernible financing cost across global equity markets. The research linked the physical climate exposure of publicly listed companies worldwide to their financing costs through cross-sectional regression analysis.

To achieve this, the analysis utilised physical risk indicators from Riskthinking.AI, which evaluate potential asset damage from ten climate hazards, including tropical cyclones, riverine and coastal flooding and heat stress. Initially, a simple correlation between physical risk and financing costs was not apparent in the raw data.

The research notes, "Initially, descriptive analysis of the raw firm-level data is unconvincing in supporting the hypothesis.".

The relationship only became clear after regression analysis was used to control for other structural factors, revealing the 22 basis point effect with a high degree of statistical significance.

Sector and regional risk pricing

The financial penalty for climate risk exposure varies considerably by industry, with asset-intensive sectors facing the highest costs.

According to the analysis, materials companies could see a 56 basis point premium per 10-point increase in physical risk, while utilities might pay 45 basis points more.

The analysis also showed a 62 basis point effect for communications firms, although Bloomberg noted this finding was less statistically robust.

"This finding is quite theoretically consistent, suggesting that capital markets are attuned to the fact that asset-intensive sectors with typically higher PPE (Property, Plant & Equipment) values are more exposed to the physical impacts of climate change," the analysis states.

Geographical location creates even starker disparities. The data from Bloomberg shows Latin American companies face a 94 basis point premium for equivalent climate exposure, which is more than four times the global average. In comparison, Asian firms might face 25 basis points in additional costs. The effect in developed markets appears to be weaker.

These regional differences were found to persist even after controlling for sectoral composition, which could suggest that the variations reflect geographical risk pricing rather than a region's industrial mix.

Disclosure and future financial strategy

These findings have implications for both corporate strategy and investors. For companies, the research could suggest that climate adaptation and resilience strategies may offer financial benefits that go beyond operational continuity.

"Corporates, on the other hand, should note that by demonstrating resilience to physical risk – through disclosure of climate risk assessments and clear adaptation plans – they may be able to lower their financing costs moving forward," the analysis concludes.

For investors, the imperative is to integrate these physical risk factors more thoroughly into valuation models and investment processes.

Bloomberg recommends investors, "look to fully integrate physical risk factors into valuations, discounted cash flow models, asset allocations and wider investment processes to maintain risk-adjusted returns as markets increasingly wake up to the realities of climate change.".

Looking ahead, global climate discussions such as the upcoming COP30 will likely examine these financial disparities.

As Barbara Buchner, Global Managing Director at the Climate Policy Initiative for the UN, says: “Success looks like getting people in the room who aren’t there yet and making sure everyone, from local to global levels, works together to scale private investment."

This highlights a growing consensus on the need for collaborative action to manage the financial repercussions of climate change.