Climate risk mispricing: Why better assessments matter in financing for development

CASCADES Policy Brief September 2022

Is climate change a financial risk that financial institutions need to worry about? Despite the rapid increase in climate financing and the rise of the dominant discourse on the importance of climate change and environmental, social and corporate governance (ESG) criteria, financial markets do not seem to show much sensitivity to the increasing climate risks. The problem arguably lies in the fact that the markets seem to have difficulties estimating the specific costs of climate change, which, although potentially high, often remain long-term and uncertain. The benefits of adjusting to climate risks also seem harder to quantify for shorter-term investments.

Most international actors that provide development finance seem to have difficulty estimating the specific costs of climate change risks. Climate risks can be low or high, short-term or long-term, and more or less uncertain. Yet, understanding the particular nature of climate risks clearly could help in pricing climate-risk finance and the proper allocation of funding for climate action. In particular, investments in climate adaptation, which are perceived by many financial actors as a costly endeavour, could become financially more attractive if the corresponding reduction in climate risk exposure were not only qualitatively considered, by explicitly priced. This would have serious implications for development finance institutions and their incentive to invest in climate adaptation operations in developing countries most affected by climate change, with a high socio-development impact.