Climate Change Risk, Sustainability and Climate Policy, and Governance
Physical vs transition risk
Physical risks are acute (floods, storms, wildfires) or chronic (sea-level rise, heat stress, drought). Transition risks arise from the shift to a low-carbon economy: policy and legal, technology, market, and reputational. Both flow into traditional risk categories (credit, market, liquidity, operational).
Policy instruments
Carbon pricing takes two main forms: a carbon tax (fixed price, uncertain abatement) and emissions trading/cap-and-trade (fixed quantity, uncertain price). Other tools include standards, subsidies, disclosure mandates, and border carbon adjustments. Traps: confusing a tax with a cap; assuming a cap sets the price (it sets quantity, price floats).
Governance
The TCFD framework (now widely codified, e.g. into ISSB) structures disclosure around four pillars: Governance, Strategy, Risk Management, Metrics and Targets. Board oversight, clear accountability, and integration of climate into enterprise risk management are central. The Paris Agreement goals (hold warming well below 2°C, pursue 1.5°C; Article 2.1(c) aligning finance flows) frame policy expectations.
Worked example
A cap-and-trade scheme sets total allowances. If demand exceeds supply, the allowance price rises - so quantity is fixed and price varies. A carbon tax fixes price and lets quantity vary. Match the instrument to which variable is controlled.
Traps
- Treating transition risk as non-financial.
- Assuming policy risk is only downside (subsidies can be upside).
- Forgetting that governance is one of four TCFD pillars, not a separate add-on.