Understanding how countries manage climate risks is important. It allows better insight of the key drivers. It also helps to differentiate risks between countries and makes it easier for investors to diversify and make informed decisions. While accounting for climate risk is essential, figuring out all these drivers and their interactions remains a major challenge.
Capturing the full scope
How climate risk is measured is essential, because lower-income nations on the frontlines of climate change, often not the chief originators of greenhouse gas emissions but certainly the main victims, need to access funding to continue building their resilience and advancing decarbonisation in a consistent way. Investors need to be assured that climate risk is being adequately captured.
Climate risk measurement typically consists of assessing a country’s physical risks, including droughts and floods with a forward-looking perspective, alongside the identification of transition risk factors that arise from societies’ response to climate change. Indeed, climate physical risks and their impacts are shaped by a country’s actions for offsetting climate shocks. Country-level actions include greenhouse gas emission reductions, transitions to renewable energy, investing in infrastructure such as climate-proofing buildings and the adoption of sustainable production practices. These are critical for climate risk mitigation and adaptation,but measuring their effectiveness to reduce physical risks remains challenging due to uncertainties in climate system responses. Accurately capturing the full scope and speed of these interventions is crucial to projecting their influence on future hazard occurrence and their severity.
Integrating climate risk into country risk
Asset managers are increasingly adapting their country risk frameworks to better integrate climate risks, reflecting the growing importance of environmental factors in investment decisions. At Triodos Investment Management, our current approach is to integrate both physical climate vulnerabilities, based on scientific assessments, and transition climate risks. These include national climate targets and decarbonisation policies, the share of renewable energy generation to phase out fossil fuel and CO₂ emissions projections. The latter are based on different factors, including country-sector activity, national transport routes and population density.
The framework also includes projections of government debt and budget needs to assess governments’ capacity to achieve their climate ambitions. Where fiscal constraints are significant, countries seek support from multilateral institutions for concessional climate-related loans. These institutions may become a meaningful mitigating source of funding, but so far their contribution is small in comparison to the scale needed and often comes with requirements for countries to implement reforms. However, climate finance is being increasingly prioritised in their efforts to advance development. They are also becoming more effective in mobilising private finance alongside their own contribution. Another crucial factor in this framework, relevant for ensuring the proper management and monitoring of climate risks, is the quality of institutions and their capacity to sustain the right policies and practices through time.
This combined approach helps identify how countries are prioritising mitigation and adaptation, as well as related financing sources and capacity to deal with long-term challenges.
Collective action to reach scale in climate finance
Physical risks can no longer be dismissed from proper country risk management frameworks, nor can the efforts from governments and multilaterals to achieve climate mitigation and adaptation. But alongside proper climate risk modelling, it's important to recognise the need for scale in climate finance and the need for different sources of finance at country level to invest in sectoral or economy-wide transformations that integrate climate and development. Ultimately, success depends not only on identifying the risks, but also on reducing them effectively with timely investments and a fair sharing of the financial burden. The sooner we act, the better our chances of averting widespread climate risks.