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Earth Day is often framed as a call to action, an opportunity to rally around policies and behaviors that mitigate environmental damage. But the challenge is not just about inspiring action; it is about understanding risk, and what this means for the wider financial landscape.

Nobel Laureate Robert Engle, co-director of the Volatility and Risk Institute at NYU, has spent years developing models to quantify financial risk. He was awarded the prize in 2003 for his methods of analyzing economic time series with varying volatility, or what is known as autoregressive conditional heteroskedasticity (ARCH). While much of his research has been applied to systemic financial risk, it has expanded in recent years to include geopolitical, cybersecurity, pandemic risks, and most importantly according to Engle, climate risk.

Climate risk is often divided into two broad categories: physical risk and transition risk. Physical risk refers to the tangible consequences of a warming planet—hurricanes, wildfires, droughts, and rising sea levels. Transition risk, on the other hand, stems from the policy and economic changes that arise to address the physical risks. This includes shifts in energy markets, the cost of decarbonization, and the financial implications of regulatory policies aimed at reducing emissions. While necessary, these shifts introduce economic uncertainties that businesses and investors must account for.

“Transition risks are the risks that we impose on ourselves,” says Engle. “It's going to affect different businesses and different people very unequally, which is why it’s hard to do this effectively, so we are trying to measure it.”

Engle’s work underscores the interconnectedness of global risks overall. He uses the banking sector and the climate risks to highlight his point. According to Engle, if a bank makes substantial loans to fossil energy companies, for example, some of those loans may be more exposed during decarbonization efforts. “If we try to solve the climate crisis, maybe we will create a financial crisis,” he says. “So one of the measures we’ve applied our metrics of banking to is the climate crisis and every day you can see what a thousand banks around the world look like from a climate health point of view. Our work and our interest has been disproportionately on the climate and on financial stability.”

Engle’s past work on financial risk proved its utility in the wake of the 2008 financial crisis, and more recently, it flagged vulnerabilities before the collapse of smaller, regional banks in the US. Similar predictive models could provide crucial foresight into climate-related economic disruptions.

Investors need reliable data to assess which sectors are most vulnerable to both physical and transition risks. Regulators must determine how to implement policies that balance environmental goals with economic stability. Without robust risk assessment, there is a danger of either overestimating or underestimating the consequences of climate change, leading to inefficient policies or market instability, which in turn can impact investors and companies.

Engle says that investors are already investing less in fossil energy companies because of climate risk assessments which has led him to coin a new term, ‘termination risk’. “I call it termination risk when there is a long term risk that your business is going to disappear,” he says. “Fossil energy companies don't think their business is going to disappear, but they must recognize that there's at least a risk that it will. I think investors know it and it’s a good direction, from a sustainability point of view, that they are actually responding to this kind of pressure.”

Engle says that countries may face termination risks and this can be linked to geopolitical risks as well. In a region like the Middle East where a major export is oil, they face a termination risk, he says. “They’re developing alternative industries,” he says. “They’re investing in all sorts of business like sports, luxury airlines, tourism so that they’ll have a future beyond oil.”

Engle sees four types of policies that governments could follow: tax carbon emissions, subsidize renewable energy and innovation in decarbonization, a combination of regulations, and the fourth policy he simply refers to as “hope.”

“I call it hope because it means that the government is really hoping that individuals, employees, governments and companies will all decide to adopt greener behavior on a voluntary basis,” he says. He acknowledges the skepticism his fellow economists have in the private sector to figure out how to do this on its own because externalities naturally lead to free riders who are unwilling to bear the burden. “Hope alone isn’t going to be sufficient,” he says. “The most important policy is really that we have to vote for elected officials that have good, sensible climate policies. And that's just a key goal.”

Economists can play a crucial role in shaping climate policy through practical, data-driven solutions. As Engle notes, the field must grapple with fundamental questions like, how much is it going to cost, how do you get capital flow, and how do you get the world to collaborate and cooperate. These challenges are both economic and political, requiring interdisciplinary approaches that blend market incentives with diplomatic strategies.

Every climate policy carries potential unintended consequences, according to Engle. Taxing emissions, for example, inevitably leads to higher energy prices, a reality that policymakers must anticipate. While higher prices can create incentives for individuals and businesses to adopt greener behaviors, they can also trigger broader economic disruptions. Inflationary pressures could force central banks to raise interest rates, leading to slowdowns reminiscent of past economic downturns.

These complexities have led to divergent policy approaches. The Biden administration, for example, prioritized subsidies over carbon taxes to avoid public backlash against higher costs. In Europe, where industries already bear substantial fees for emissions, the debate over border adjustments—taxing imports from countries with weaker environmental regulations—is gaining traction. "Border adjustment is one of the solutions to that,” says Engle. “And that is coming.”

Ultimately, economics provides the analytical tools to navigate these trade-offs, ensuring that climate policies are both effective and politically viable. By refining models, assessing costs, and predicting market responses, economists can help policymakers strike a balance between ambitious climate goals and economic stability.

As climate risks grow, the need for transparent, data-driven assessments will only increase. Engle’s work provides a roadmap for how risk modeling can be leveraged to drive better decision making. By quantifying climate risk with the same rigor applied to financial volatility, institutions, businesses, and governments can better prepare for the uncertainties ahead.

“This is a challenge when you get invited to give a talk and you're a Nobel Laureate, they expect something really important,” says Engle. “And one of the things that I've done here is to try to refocus my research so that I have things to say about the great questions of our times.”