Climate Related Financial Risks and Their Implications on Investment Portfolios

Abstract

This study reviews how climate related financial risks shape asset pricing and portfolio management. Climate change generates physical and transition risks that affect expected cash flows, discount rates, and risk premia, making climate risk a material driver of portfolio performance and financial stability. Using a systematic literature review of peer reviewed studies, the paper synthesizes evidence on how climate risk is priced across equities, bonds, real estate, and derivatives, and how green and brown assets exhibit distinct return patterns. The findings show that climate risk is reflected in cross section returns, option implied tail risk, and time varying green brown performance differentials driven by policy, technology, and investor sentiment. Climate aware portfolio strategies such as tilting toward low emission firms, excluding high carbon sectors, and constructing climate hedge factors can reduce exposure to transition risk but may alter expected returns and diversification benefits. The review identifies a key gap in holistic multi asset frameworks and calls for integrated portfolio models that embed climate scenarios, cross asset hedging opportunities, and long horizon uncertainty. These insights provide guidance for constructing resilient, climate aware portfolios across investment horizons.