Abstract
Over the past fifteen years, responsible investment has evolved, shifting from broad ESG scores to more granular climate risk management. Transition risk has dominated, with portfolio decarbonization anchored in standardized carbon intensity metrics and, more recently, complemented by measures of green intensity. Frameworks such as comprehensive integrated and core-satellite approaches now give investors effective tools to integrate transition risks into portfolio construction. In contrast, physical climate risk remains underdeveloped. Rising extreme weather events, chronic temperature increases, and ecosystem disruptions are already affecting asset values and supply chains. However, there is no standardized equivalent to carbon or green intensity for benchmarking.
This paper argues that physical climate risk must now receive the same attention as transition risk. Unlike transition risk, physical climate risk lacks clear anchor metrics. This methodological gap explains why portfolio optimization that incorporates physical risk is still in its infancy. We review transition and physical risk modeling and discuss approaches for constructing physical risk scores. We also examine how to integrate these scores into portfolio optimization and strategic asset allocation. Our analysis shows that achieving significant reductions in both exposure and vulnerability to physical climate risk is extremely challenging. Moreover, the high shadow price associated with these mitigation policies suggests substantial implementation costs and trade-offs. Overall, we conclude that incorporating physical climate risk into portfolio management is considerably more complex than managing transition risk.
Authors
