How Climate Risk Can Affect a Company's Cost of Capital

A Financial Risk, Not Just a Reputational One

For years, climate change was mainly a topic for sustainability reports. That is changing. Lenders, insurers and regulators increasingly treat it as a financial risk that can change a company's cash flows and its cost of funding. For analysts, the question is how it enters a valuation.

Two Kinds of Climate Risk

Physical risk comes from the climate itself: heatwaves that cut worker productivity, floods that shut plants, droughts that reduce water for industry, and weak monsoons that hurt rural demand. In 2026, India's southwest monsoon ended 13% below its long-period average, a reminder that weather still moves the economy.

Transition risk comes from the shift to a lower-carbon economy: carbon pricing, emission limits, new technology that makes old assets less valuable, and changes in what customers and investors will accept.

The Transition Is Arriving in India

• India's Carbon Credit Trading Scheme. In October 2025, the government notified greenhouse gas emission intensity targets for aluminium, cement, chlor-alkali, and pulp and paper plants, and in January 2026 added refineries, petrochemicals, textiles and secondary aluminium. Plants that beat their targets earn tradable carbon credit certificates; those that miss must buy and surrender them. The first compliance years are FY2025-26 and FY2026-27.
• The EU's Carbon Border Adjustment Mechanism (CBAM). From January 2026, CBAM entered its definitive phase, putting a carbon cost on certain imports into the EU, including steel and aluminium. Indian exporters in these sectors face a direct cost based on the carbon content of their products.
• Lenders and regulators. The RBI has proposed a disclosure framework for climate-related financial risks at regulated entities, which will push banks to measure the climate exposure of their loan books.

Two Paths Into Valuation

Path 1: Cash flows. Carbon costs, compliance spending, higher insurance premiums, lost exports and damage from extreme weather all reduce future cash flows. Assets that become uneconomic early, sometimes called stranded assets, shorten the life of the cash flows.

Path 2: The cost of capital. If lenders see more risk, they charge more or lend for shorter periods. If equity investors see more uncertainty, or some refuse to own the shares at all, the cost of equity can rise. Cost of capital basics are in The Vault.

A Worked Example: Two Ways to Model One Risk

Illustrative example. A company generates ₹500 crore of free cash flow a year, growing 4% forever, with a cost of capital of 11%. Its value is about ₹7,143 crore.

• Cash flow approach: carbon costs cut free cash flow by 8%, to ₹460 crore. Value falls to about ₹6,571 crore, down 8%.
• Discount rate approach: instead, add 0.5 percentage points to the cost of capital. Value falls to about ₹6,667 crore, down about 7%.

Both approaches can be defended. But using both for the same risk counts it twice. If you have already put a carbon cost into the cash flows, raising the discount rate for the same carbon risk overstates the effect.

The cash flow approach is usually better when the risk can be estimated, such as a known carbon price. The discount rate approach suits risks that are real but hard to put numbers on.

Lenders' Growing Questions

The cost-of-capital channel works mainly through lenders. Banks and bond investors are beginning to ask borrowers about emissions, transition plans and exposure to extreme weather. In practice, this can show up in several ways: shorter loan tenors for carbon-heavy assets, higher spreads for borrowers without credible plans, covenants linked to emissions, or sustainability-linked loans that cut the interest rate when targets are met.

For a capital-intensive business, a shorter tenor can matter as much as a higher rate. A plant built to last thirty years but financed with seven-year loans faces refinancing risk every few years, and each refinancing is a chance for lenders to reprice the climate risk.

Physical Risk in Numbers

Illustrative example. A manufacturing plant earns ₹2 crore of EBITDA a day. If floods or extreme heat shut it for ten days a year more than in the past, the annual loss is ₹20 crore, before any repair costs or higher insurance premiums. For a plant earning ₹600 crore a year, that is over 3% of EBITDA, every year, from a risk that may not appear anywhere in the company's guidance.

Location data, such as flood maps and water stress indicators, can help estimate this exposure for each major plant.

Sectors Most Exposed

• High emitters: cement, steel, aluminium, power, refining and chemicals face transition costs directly.
• Exporters to Europe in CBAM sectors.
• Agriculture-linked businesses and rural consumption, exposed to monsoon and heat.
• Lenders and insurers with concentrated exposure to the above.

Exposure is not the same as risk. A cement company investing in waste heat recovery, renewable power and blended cements may face lower carbon costs than its rivals.

Habits for Assessing Climate Risk

1. Read the BRSR for emissions, energy use and emission intensity.
2. Check which sectors fall under carbon market targets or CBAM.
3. Estimate carbon costs per unit of output under a few carbon prices.
4. Look at physical locations of plants for flood, heat and water stress.
5. Choose one modelling path for each risk and stick to it.

The Reframe

Climate risk does not need a separate valuation. It needs to be put into the same cash flows and discount rates as every other risk, honestly, and only once.