2 - Extra-financial risks in sustainable finance

Extra-financial risks refer to Environment, Social and Governance (ESG) factors that are not directly visible in traditional financial statements but can significantly affect cash flows, risk premia and asset values. They are typically long-term, uncertain in the short term, sometimes irreversible, and strongly shaped by regulatory, political and societal dynamics. In sustainable finance, these risks are no longer seen as "non-financial".

2.1 Definition of Extra-Financial Risks

Extra-financial risks refer to risks that are not directly captured by traditional financial statements, but which may nonetheless have a material impact on firms' financial performance, asset valuation, and long-term viability.

These risks are generally associated with Environmental, Social and Governance (ESG) factors. Unlike conventional financial risks (market risk, credit risk, liquidity risk), extra-financial risks are often:

• long-term in nature,

• uncertain and difficult to quantify,

• non-linear and potentially irreversible,

• highly dependent on regulatory, environmental and social dynamics.

In the context of sustainable finance, extra-financial risks are no longer considered non-financial in substance. They are financially material risks once their transmission to cash flows, discount rates or risk premia is recognized.

In sustainable finance, physical risks are the financial impacts stemming from the direct, tangible effects of climate change (for example, storms, floods, heatwaves, sea-level rise, or long-term shifts in temperature and precipitation) on assets, operations, and supply chains. They can damage infrastructure and property, disrupt production and logistics, and reduce asset values or collateral quality, which in turn affects companies, banks, and investors. Reinsurance companies are on the frontline and have become experts in economic losses projections when it comes to physical risks.

Transition risks are the financial impacts linked to the shift toward a low‑carbon, more sustainable economy, driven by new climate policies, regulations, technologies, market preferences, and social or reputational pressures. They can arise, for instance, from stricter carbon regulation (carbon price, bans), rapid technological change (cheaper renewables), or changing consumer demand, which may devalue high‑carbon business models and create stranded assets in sectors like fossil fuels or energy‑intensive industries.

2.2 Main Categories of Extra-Financial Risks

2.2.1 Environmental Risks

Environmental risks arise from the degradation of natural capital and the crossing of planetary boundaries. They include, in particular:

• climate change risks (transition risks and physical risks)

• biodiversity loss,

• natural resource depletion,

• pollution of air, water and soil.

These risks can affect companies through several channels:

• physical damage to assets caused by extreme climate events,

• disruptions to supply chains,

• increased regulatory constraints (carbon pricing, environmental standards),

• stranded assets, whose economic value collapses due to regulatory or technological change.

The handbook emphasizes that environmental risks are closely linked to negative externalities that were historically ignored by standard financial and economic models, but which must now be internalized.

2.2.2 Social Risks

Social risks relate to a company's interaction with its human stakeholders, including:

• employees,

• suppliers,

• customers,

• local communities.

They encompass issues such as:

• working conditions and labor rights,

• health and safety,

• human rights violations in supply chains,

• inequality and social exclusion.

Social risks may translate into financial losses through:

• legal sanctions and litigation,

• reputational damage,

• productivity losses,

• disruptions in operations or sourcing.

In sustainable finance, social risks are increasingly viewed as drivers of long-term performance, particularly in sectors with high labor intensity or global supply chains.

2.2.3 Governance Risks

Governance risks stem from the organizational and institutional structure of firms. They include:

• weak board oversight,

• lack of transparency,

• corruption and fraud,

• misalignment between management incentives and long-term value creation.

Poor governance can amplify environmental and social risks by preventing their proper identification and management. The handbook highlights governance as a central transmission mechanism, through which ESG risks become financially material.

2.3 From Extra-Financial Risk to Financial Risk

A key contribution of sustainable finance is to show that extra-financial risks are not separate from financial risks, but rather upstream risk factors.

They can affect:

• expected cash flows (via costs, revenues, or capital expenditures),

• the cost of capital (through higher risk premium),

• asset prices and portfolio returns.

For example:

• higher carbon emissions may increase transition risk and future costs,

• biodiversity loss may threaten business models dependent on ecosystem services,

• weak governance may increase volatility and downside risk.

This perspective justifies the integration of ESG factors into risk management, asset pricing and portfolio construction.

2.4 Measurement and Assessment of Extra-Financial Risks

The measurement of extra-financial risks relies on:

• ESG data and indicators,

• scoring and rating systems,

• quantitative risk metrics (carbon footprint, biodiversity exposure, social indicators).

However, there are several limitations:

• data can be noisy, incomplete or inconsistent,

• methodologies differ across providers (although this will be different after data providers' regulation starting in July 2026),

• ESG scores are not directly comparable to financial risk measures.

As a result, extra-financial risk assessment remains an imperfect but necessary exercise, requiring both quantitative tools and qualitative judgment with robust methodologies.

2.5 Extra-Financial Risks and Double Materiality

A central concept in sustainable finance is double materiality:

• financial materiality: how earth ecosystems (biodiversity) affect the firm's financial performance,

• impact materiality: how the firm's activities affect earth ecosystems (biodiversity).

Extra-financial risks sit at the intersection of these two dimensions. Environmental and social impacts can eventually feed back into financial risk through regulation, market preferences or physical constraints.

Conclusion

Extra-financial risks are a cornerstone of sustainable finance. They challenge traditional financial theory by highlighting the importance of long-term and systemic risks.

Understanding and managing these risks is essential for:

• investors seeking resilient portfolios,

• firms aiming at sustainable value creation,

• regulators designing frameworks aligned with environmental and social constraints.

In this sense, extra-financial risks are not peripheral to finance — they are structural risks of the 21st century economy.