Explainer: Risk management & portfolio construction — a practical primer for teams that need to ship

In 2024, global climate-related financial losses exceeded $380 billion, while institutional investors managing over $130 trillion in assets now incorporate climate risk factors into portfolio construction decisions (Swiss Re, 2025). The Network for Greening the Financial System (NGFS) reported that 85% of central banks and financial supervisors have begun integrating climate scenario analysis into their stress-testing frameworks, a dramatic increase from just 42% in 2021. For sustainability teams tasked with operationalizing climate risk management, the imperative has shifted from theoretical frameworks to practical implementation—measuring physical and transition risks, constructing portfolios that balance return optimization with climate resilience, and avoiding the trap of "measurement theater" where data collection substitutes for genuine risk mitigation.

Why It Matters

Climate risk management and portfolio construction sit at the intersection of fiduciary duty, regulatory compliance, and strategic positioning. The Task Force on Climate-related Financial Disclosures (TCFD), now consolidated under the International Sustainability Standards Board (ISSB), has established disclosure requirements that affect over 4,000 companies globally. The European Union's Sustainable Finance Disclosure Regulation (SFDR) and the SEC's climate disclosure rules (finalized in 2024) create binding obligations for asset managers and corporations to quantify, report, and manage climate-related financial risks.

The financial materiality of climate risk extends across multiple vectors. Physical risks—including acute events like hurricanes, floods, and wildfires, as well as chronic shifts in temperature and precipitation patterns—threaten asset values directly. The 2024 California wildfire season alone generated $28 billion in insured losses, with cascading effects on real estate valuations, supply chain reliability, and municipal bond creditworthiness. Transition risks arise from policy changes, technological disruption, and shifting market preferences as economies decarbonize. Carbon-intensive sectors face stranded asset risk: the Carbon Tracker Initiative estimates that $1.4 trillion in oil and gas assets could become uneconomic under a 1.5°C pathway.

For portfolio managers, the challenge lies in integrating these risks into traditional factor models without sacrificing returns. Research from MSCI and Morningstar demonstrates that climate-aware portfolios have historically matched or exceeded conventional benchmarks while reducing exposure to tail risks. The 2024 Global Sustainable Investment Review found that sustainable investment strategies now represent 36% of professionally managed assets in major markets, up from 22% in 2018. This is not a niche concern—climate risk management has become foundational to institutional investment practice.

Key Concepts

Climate Risk Taxonomy

Climate risks divide into two primary categories recognized by the TCFD framework:

Physical Risks encompass both acute events (storms, floods, heatwaves) and chronic patterns (sea-level rise, temperature increase, water stress). These risks manifest as asset impairment, operational disruption, and liability exposure. Physical risk assessment requires geospatial analysis mapping asset locations against climate hazard projections under multiple scenarios.

Transition Risks emerge from the economic transformation toward low-carbon systems. Policy risks include carbon pricing, emissions regulations, and fossil fuel subsidy removal. Technology risks involve competitive displacement by cleaner alternatives. Market risks reflect shifting consumer and investor preferences. Reputation risks arise from perceived climate inaction.

Factor Models and Climate Integration

Traditional portfolio construction relies on factor models—systematic frameworks identifying return drivers such as value, momentum, quality, and size. Climate-aware portfolio construction introduces additional factors:

Factor Category	Climate Integration	Measurement Approach
Carbon Intensity	Scope 1, 2, 3 emissions per revenue	tCO2e / $M revenue
Physical Risk Exposure	Asset-level hazard mapping	Value-at-Risk by scenario
Transition Readiness	Decarbonization pathway alignment	Temperature score (°C)
Stranded Asset Risk	Reserve replacement and capex allocation	% fossil fuel dependency
Green Revenue Share	Revenue from climate solutions	% taxonomy-aligned revenue

Scenario Analysis and Stress Testing

Climate scenario analysis projects portfolio performance under alternative futures. The NGFS provides standardized scenarios ranging from orderly transitions (Net Zero 2050) to disorderly transitions (delayed action) to hot house worlds (current policies). Effective stress testing requires:

Time Horizons: Short-term (1-5 years) for transition risks; medium-term (5-15 years) for combined effects; long-term (15-50+ years) for physical risk materialization
Sector Granularity: Differentiated impacts across industries, with energy, materials, utilities, and transportation facing highest exposure
Geographic Specificity: Location-based physical risk assessment using downscaled climate projections

Value-at-Risk and Climate VaR

Climate Value-at-Risk (Climate VaR) extends traditional VaR methodology to quantify potential losses from climate-related events. Physical Climate VaR estimates property damage, business interruption, and supply chain costs under warming scenarios. Transition Climate VaR models portfolio impacts from policy implementation, technological shifts, and demand changes. Leading methodologies include those developed by MSCI, Ortec Finance, and Carbon Delta (now part of MSCI).

What's Working and What Isn't

What's Working

Integrated Climate Data Platforms: The consolidation of climate risk data providers has improved data accessibility and consistency. Platforms integrating physical risk modeling (e.g., Jupiter Intelligence, Four Twenty Seven/Moody's), emissions data (CDP, S&P Trucost), and transition pathway analysis (Science Based Targets initiative) enable holistic portfolio assessment. Asset managers report that unified data platforms reduce implementation time by 40-60% compared to bespoke data integration efforts.

Sector-Specific Decarbonization Frameworks: The Transition Pathway Initiative (TPI) and Climate Action 100+ engagement frameworks provide sector-specific benchmarks for evaluating company climate performance. These frameworks establish credible pathways for high-emitting sectors including oil and gas, electric utilities, steel, cement, and aviation. Portfolio managers can benchmark holdings against sector trajectories and identify laggards requiring engagement or divestment.

Regulatory Alignment Driving Standardization: Mandatory disclosure requirements have accelerated data availability and comparability. The EU Taxonomy provides a classification system for environmentally sustainable activities, while the ISSB's IFRS S1 and S2 standards establish globally applicable climate disclosure frameworks. This regulatory convergence reduces "greenwashing" risk and provides defensible standards for portfolio construction decisions.

Engagement Over Divestment: Evidence from Climate Action 100+ and similar initiatives demonstrates that coordinated shareholder engagement can drive corporate climate action more effectively than divestment alone. Since 2017, Climate Action 100+ signatories (representing over $68 trillion in assets) have secured commitments from 75% of focus companies to achieve net-zero emissions by 2050. Engagement preserves portfolio diversification while influencing real-economy emissions.

What Isn't Working

Scope 3 Data Quality: Scope 3 emissions (value chain emissions) represent 70-90% of total emissions for most companies but remain poorly measured and inconsistently reported. Estimation methodologies vary widely, with disclosed Scope 3 figures differing by 30-50% across data providers for identical companies. This uncertainty complicates portfolio carbon footprinting and transition risk assessment.

Short-Term Performance Pressure: Quarterly performance evaluation cycles conflict with the multi-decadal timeframes over which climate risks materialize. Portfolio managers face pressure to demonstrate near-term outperformance while managing risks that may not crystallize for years or decades. This temporal mismatch creates implementation challenges for climate-aware strategies.

Model Uncertainty in Physical Risk Assessment: Physical risk models depend on climate projections, asset-level exposure data, and vulnerability assumptions—each introducing uncertainty. Different providers generate substantially different risk estimates for identical portfolios, making it difficult to compare assessments or set portfolio-level risk tolerances. Model transparency and validation remain industry challenges.

Measurement Theater: Some organizations prioritize disclosure compliance over genuine risk management, generating extensive reports without integrating findings into investment decisions. The proliferation of ESG ratings and rankings can create perverse incentives to optimize reported metrics rather than manage underlying risks. Effective implementation requires embedding climate considerations into investment processes, not merely reporting them.

Key Players

Established Leaders

BlackRock: The world's largest asset manager ($10+ trillion AUM) has integrated climate risk analysis across its investment platform through its Aladdin Climate module. BlackRock publishes TCFD-aligned reports and offers climate-focused ETFs and index strategies.

MSCI: A dominant provider of ESG and climate data, MSCI offers Climate VaR models, temperature alignment metrics, and physical risk assessments used by institutional investors globally. Their acquisition of Carbon Delta strengthened transition risk capabilities.

Moody's Analytics: Through its acquisition of Four Twenty Seven, Moody's provides physical climate risk scores for real assets and corporate exposures. Their models integrate with credit risk assessment frameworks used by banks and institutional investors.

S&P Global (Trucost): Trucost provides carbon emissions data covering over 15,000 companies, enabling portfolio carbon footprinting and climate scenario analysis. Their Environmental Cost Valuation methodology quantifies externalities in financial terms.

PIMCO: A leading fixed-income manager, PIMCO has developed climate-aware bond strategies and pioneered climate risk integration in sovereign debt analysis, assessing country-level physical and transition risks.

Emerging Startups

Jupiter Intelligence: Provides high-resolution physical climate risk analytics for real assets, combining downscaled climate projections with asset-specific vulnerability models. Clients include major banks, insurers, and real estate investors.

Watershed: Offers an enterprise carbon management platform helping companies measure, report, and reduce emissions across operations and supply chains. Their audit-grade data supports climate-aligned portfolio construction.

Cervest: Delivers asset-level climate intelligence using AI-driven analysis of physical risk exposure. Their EarthScan platform provides risk scores for individual properties and aggregated portfolio assessments.

Clarity AI: Provides sustainability analytics covering over 30,000 companies, integrating climate metrics with broader ESG assessment. Their technology platform supports regulatory reporting and investment screening.

OS-Climate: An open-source initiative backed by major financial institutions developing shared climate risk analytics tools. Their collaborative model aims to reduce duplication and improve data accessibility across the industry.

Key Investors & Funders

Generation Investment Management: Co-founded by Al Gore, Generation has pioneered sustainable equity strategies and demonstrated long-term performance of climate-integrated investing. Managing over $36 billion, they influence industry standards through thought leadership and practice.

Breakthrough Energy Ventures: Bill Gates-founded climate tech fund deploying over $2 billion across clean energy, agriculture, and industrial decarbonization. Their investments signal technology readiness for transition-aligned portfolios.

CDPQ (Caisse de dépôt et placement du Québec): A $400+ billion Canadian pension fund that has committed to portfolio decarbonization and invested heavily in renewable energy infrastructure, demonstrating institutional appetite for climate-aligned strategies.

European Investment Bank (EIB): The EU's climate bank has committed to aligning all financing with Paris Agreement goals and provides concessional capital for climate projects, de-risking investments for private capital.

U.S. Department of Energy Loan Programs Office: With over $400 billion in lending authority, the LPO catalyzes commercial-scale deployment of clean energy technologies, reducing technology risk for climate-focused investors.

Examples

Norges Bank Investment Management (Norwegian Government Pension Fund Global): The world's largest sovereign wealth fund ($1.4+ trillion) has implemented comprehensive climate risk management, including coal and oil sands exclusions, engagement programs with high-emitting companies, and physical risk assessment of real estate holdings. Their 2024 climate action plan establishes interim portfolio decarbonization targets and sector-specific expectations, demonstrating how large institutional investors can operationalize climate risk frameworks while maintaining diversification and returns.
Allianz Global Investors: Allianz has developed an integrated climate risk framework combining physical risk mapping (using satellite imagery and climate models for real asset exposure), transition risk scoring (assessing alignment with 1.5°C pathways), and engagement programs. Their Climate Risk Investment Positioning (CRIP) framework informs asset allocation and security selection across multi-asset portfolios. In 2024, they reported that climate-tilted strategies outperformed conventional benchmarks by 120 basis points over a three-year period while reducing carbon intensity by 45%.
CalPERS (California Public Employees' Retirement System): As one of the largest U.S. public pension funds ($500+ billion), CalPERS has integrated climate risk into strategic asset allocation decisions and adopted a net-zero portfolio target for 2050. Their approach combines portfolio decarbonization with active engagement through Climate Action 100+, and they have pioneered litigation against fossil fuel companies on climate-related securities fraud grounds. CalPERS demonstrates how fiduciary duty increasingly encompasses long-term climate risk management.

Sector-Specific KPIs

Sector	Primary Climate KPI	Target Range	Measurement Frequency
Electric Utilities	Carbon Intensity (gCO2/kWh)	<100 by 2030	Annual
Oil & Gas	Scope 1+2+3 Emissions Reduction	-45% by 2030 vs 2019	Annual
Real Estate	Physical Risk VaR (% portfolio)	<5% under RCP 4.5	Biennial
Banking	Financed Emissions (tCO2e/$M)	<50 by 2030	Annual
Materials (Steel, Cement)	Emissions Intensity Reduction	-30% by 2030	Annual
Automotive	EV Sales Share	>50% by 2030	Quarterly
Agriculture & Food	Land Use Emissions	-25% by 2030	Annual

Action Checklist

Conduct a portfolio-level climate risk assessment using TCFD-aligned methodology, covering both physical and transition risks across all asset classes
Establish data infrastructure by selecting and integrating climate risk data providers (emissions data, physical risk models, scenario analysis tools) into existing portfolio management systems
Define climate risk tolerances and portfolio-level targets, including carbon intensity reduction pathways and maximum acceptable Climate VaR thresholds
Implement climate factors in security selection and portfolio construction, incorporating carbon intensity, transition readiness, and physical risk exposure into factor models
Develop an engagement program for high-emitting holdings, establishing escalation protocols from dialogue to voting action to potential divestment
Align disclosure practices with ISSB/TCFD standards, ensuring climate risk reporting integrates with financial disclosures and is subject to appropriate governance
Establish monitoring and review cycles to track portfolio climate metrics, assess scenario analysis outcomes against emerging data, and adjust strategies as climate science and policy evolve

FAQ

Q: How do we balance climate risk management with fiduciary duty to maximize returns? A: Fiduciary duty increasingly encompasses long-term systemic risks, including climate. Legal opinions from organizations like the Principles for Responsible Investment confirm that failing to consider financially material climate risks may itself breach fiduciary duty. Empirical evidence from MSCI, Morningstar, and academic research demonstrates that climate-aware portfolios have historically matched or exceeded risk-adjusted returns of conventional benchmarks. The key is integrating climate as a financial risk factor rather than treating it as a constraint that sacrifices returns.

Q: What's the difference between portfolio decarbonization and real-world emissions reduction? A: Portfolio decarbonization reduces the carbon intensity of holdings—often achieved by divesting from high emitters or tilting toward lower-carbon companies. However, this doesn't necessarily reduce real-world emissions; divested assets transfer to other owners without changing corporate behavior. Real-world impact requires engagement that changes company practices or capital allocation to climate solutions that displace emissions. Effective strategies combine portfolio positioning with active ownership and investment in additionality-generating solutions.

Q: How should we handle Scope 3 data quality issues? A: Acknowledge uncertainty explicitly rather than treating reported Scope 3 figures as precise. Use multiple data sources and compare estimates; significant divergence indicates measurement limitations. Focus on sector-level materiality—Scope 3 matters most for sectors like oil and gas (product use), automotive (vehicle operations), and consumer goods (supply chains). Engage companies to improve disclosure quality over time. For portfolio construction, consider Scope 3 directionally rather than optimizing to precise figures that may be unreliable.

Q: How frequently should we update climate scenario analysis? A: Climate scenario analysis should be refreshed at least annually to incorporate evolving climate science, policy developments, and company-level data. However, full portfolio re-analysis is resource-intensive; many institutions conduct comprehensive assessments biennially while monitoring key indicators quarterly. Trigger-based reviews are warranted following major policy changes (new carbon pricing, regulatory shifts), significant portfolio changes, or updated IPCC or NGFS scenario releases.

Q: What distinguishes measurement theater from genuine climate risk management? A: Measurement theater produces reports and metrics without influencing investment decisions. Genuine climate risk management embeds climate factors into investment processes—security selection, portfolio construction, risk limits, and engagement priorities. Indicators of authentic integration include: climate metrics in investment committee materials, documented decision-making where climate factors affected outcomes, compensation linkage to climate targets, and board-level oversight of climate risk. If climate data exists only in sustainability reports disconnected from investment operations, the organization is likely engaged in measurement theater.

Sources

Swiss Re Institute. (2025). Natural catastrophes in 2024: A year of escalating losses. Sigma No. 1/2025.
Network for Greening the Financial System. (2024). NGFS Climate Scenarios for Central Banks and Supervisors. Technical documentation.
Task Force on Climate-related Financial Disclosures. (2023). Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures.
Carbon Tracker Initiative. (2024). Stranded Assets: Fossil Fuels and the Energy Transition. Industry analysis report.
Global Sustainable Investment Alliance. (2024). Global Sustainable Investment Review 2024.
MSCI. (2024). Climate Value-at-Risk Methodology: Technical Guide.
Climate Action 100+. (2025). 2024 Progress Report: Global investor engagement with systemically important emitters.
International Sustainability Standards Board. (2024). IFRS S2 Climate-related Disclosures.