In the dynamic realm of banking and financial institutions, the landscape is undergoing a transformative shift due to the impacts of climate change. As extreme weather events become more prevalent, the financial sector finds itself at the forefront of challenges and opportunities.


Policymakers and investors within this domain are acutely aware of the implications that climate change carries for financial institutions. In this article, we embark on a comprehensive exploration of climate risk intricacies, investigating potential financial implications specific to banks and financial entities. Additionally, we outline common approaches for effective risk assessment in this ever-evolving financial terrain.


What is Climate Risk?


Transition and Physical Risk

Climate risk consists of two key components: physical risks and transition risks. Physical risks encompass the direct and indirect consequences of climate-related damage to property, infrastructure, and land, affecting businesses in various ways.


On the other hand, transition risks result from the dynamic shifts in climate policies, technology, and market sentiments during the transition to a low-carbon economy. These dual components present a comprehensive challenge for financial institutions as they navigate immediate impacts and adapt to the evolving landscape of climate-related factors.


Potential Financial Implications

Impact on Financial Institutions

Physical risk poses significant challenges for banks in two main ways. Firstly, through direct exposure, imagine an individual obtaining a loan to buy a property, like a house or a factory. If an adverse event, such as a flood or storm, occurs, it can damage the property, reducing its overall value. This loss of value becomes problematic as it diminishes the asset’s ability to serve as adequate collateral for the loan, potentially exposing the bank to higher risks in terms of loan recovery and financial stability.


The second challenge, involving indirect exposure, is a bit more intricate. Picture a scenario where a business has borrowed funds from the bank. If an unforeseen event, like a natural disaster, disrupts the operations of the business, it may face difficulties in production and generating revenue.


This reduced capacity to operate affects the business’s reliability in repaying the loan, and in severe cases, it might face insolvency. Consequently, the bank not only contends with the decreased value of the impaired property (e.g., the house or factory) but also grapples with the financial strain resulting from the struggling business. In essence, it’s a dual impact, creating a considerable challenge for the bank.


Looking at insurers and reinsurers, physical risk unfolds in a distinct way. More insurance claims and higher claim losses are changing the insurance industry. This could make it harder to get coverage, especially in areas at high risk for physical damage. Simply put, the increased frequency and severity of claims put a strain on the insurance industry, impacting its capacity to offer coverage in areas prone to adverse physical events.


Transition risk impacts banks and insurance companies through potential financial repercussions stemming from changes in environmental policies, particularly those related to carbon pricing. Imagine a scenario where the government decides to tackle climate change by raising carbon prices significantly. This directly affects businesses heavily reliant on fossil fuels.


The local bank, with investments in these carbon-intensive sectors, sees a decline in the value of its portfolio as these companies face higher operational costs. Concurrently, insurance companies experience similar impacts on their investment portfolio. In this case, the shift in carbon prices directly impacts the financial health and risk assessments of both banks and insurance companies.


Financial Stability Concerns

Risks also extend to the broader economy, particularly if the transition to a low-carbon economy is abrupt or poorly coordinated globally. Financial stability concerns arise when asset prices adjust rapidly to reflect unforeseen climate risks.


Central banks and financial regulators acknowledge these implications and are integrating climate-related risks into supervisory frameworks. Stress tests that incorporate climate risk scenarios are becoming essential tools for assessing the resilience of financial institutions.


A recent report was released in December 2023 by the European Central Bank and the European Systemic Risk Board. The report discusses the impact of climate change on the financial system of the European Union. It was published in December 2023. It highlights banks’ critical role in managing stability risks arising from emissions in the EU economy, with significant exposure to high-emitting firms and households.


The proposed macroprudential strategy aims to systematically address climate-related risks, extending its scope to broader nature-related risks. The report advocates for a comprehensive approach, focusing on managing risks for both the banking sector and borrowers, as well as addressing risks in non-bank financial intermediation.


The report suggests using existing instruments in the EU macroprudential toolkit, such as systemic risk buffers[1] and risk concentration limits[2], for targeted and scalable management of climate-related financial stability risks. Additionally, it explores the potential risks posed by nature degradation to financial stability, emphasizing financial institutions’ dependence on ecosystem services. This comprehensive analysis aligns with the ECB’s broader response to climate change, including stress tests and risk management expectations for supervised banks.


Assessing the risk

Stress testing and scenario analyzing

In the realm of climate transition risk management, financial institutions employ sophisticated tools and methodologies. One powerful approach involves stress testing combined with scenario analysis. This method allows institutions to simulate plausible scenarios, considering shifts in climate policies, technological advancements, and market sentiments. By subjecting portfolios to these scenarios, institutions gain strategic foresight—similar to a financial weather report—to navigate the complexities of the ongoing transition.


The Network for Greening the Financial Sector (NGFS) defines climate scenarios, categorized as orderly, disorderly, and “hot house world,” each unfolding distinct levels of physical and transition risks. In this journey of scenario analysis, where institutions must discern which investments to shock, NGFS scenarios provide a structured framework.


Assets are selected based on the specific climate scenario, injecting a level of realism into stress testing and enabling institutions to gauge their resilience under diverse climate-related circumstances.


Climate Policy Relevant Sectors (CPRS) classification

To dive into assessing climate transition risk in portfolios, financial institutions turn to the Climate Policy Relevant Sectors (CPRS) classification, a strategic tool introduced by Battiston et al. in 2017. This tool provides a systematic and actionable categorization of economic activities, considering factors such as their role in the energy value chain, greenhouse gas emissions, policy processes, and business models.


This categorization ensures a standardized approach and enhances the financial sector’s capability to evaluate investors’ exposure to climate transition risk. The CPRS classification has been utilized by various institutions and policymakers, including the European Central Bank ECB) (2019), the European Insurance and Occupational Pensions Authority (EIOPA) (2019, 2020), and the European Banking Authority (EBA) (2020, 2021).


As financial institutions align with the urgency of mitigating climate change, the CPRS classification becomes a linchpin for understanding and addressing climate transition risk. It offers a replicable and comparable classification of economic activities across portfolios and jurisdictions, going beyond the traditional concept of “carbon stranded assets”. Moreover, it aligns seamlessly with the EU Taxonomy of sustainable activities.


By leveraging the CPRS classification, financial institutions can comprehensively assess climate financial risks, fostering a deeper understanding of how revenues from diverse economic activities might be impacted during a disorderly low-carbon transition. Internationally recognized and applied, CPRS stands as a beacon in the finance sector’s efforts to navigate the complex terrain of climate transition risk.


Regulatory landscape

The Basel Framework

While the Basel regulatory framework currently lacks specific capital requirements tailored to climate risks, it’s widely acknowledged that integrating these risks into the framework is not a matter of if, but when.


The Basel Committee on Banking Supervision (BCBS) has taken proactive steps in this direction by issuing clarifications in response to frequently asked questions (FAQs) in December 2022. These FAQs provide guidance on how banks can incorporate climate-related financial risks into existing Pillar 1 standards of Basel III without necessitating changes to the standards themselves.


Additionally, the BCBS has recognized climate-related financial risks as an essential aspect of the Basel Core Principles, which serve as universal standards for sound banking regulation and supervision. Amendments to certain core principles would require supervisors to factor climate risks into their methodologies and processes, underscoring the growing importance of addressing climate risks within banking regulation.



The International Monetary Fund’s Role

The IMF, with its core mandate of analyzing risks and vulnerabilities, recognizes the need to integrate climate change risks into macro-financial policies. Improved stress tests, focusing on physical and transition risks, are crucial for understanding the macro-financial transmission of climate risks.


Closing data gaps through standardized reporting and climate disclosures is essential for informed decision-making. The IMF collaborates with central banks, supervisors, and international organizations to develop frameworks for assessing climate-related risks.


As we navigate the economic costs of climate change, finance emerges as a key player in managing the transition. With thoughtful policies, risk-aware institutions, and sustainable investments, the financial sector can contribute significantly to building a resilient and sustainable future for generations to come.


Building Resilience: Navigating Climate Risks in Finance

In conclusion, as we wrap up our exploration of climate risk in the financial landscape, it’s evident that climate change poses both challenges and opportunities for banks and financial institutions. With the increasing frequency of extreme weather events and the transition to a low-carbon economy, it’s imperative for the financial sector to adapt and innovate.


Through stress testing, scenario analysis, and tools like the Climate Policy Relevant Sectors (CPRS) classification, institutions can gain insights into their exposure and develop strategies to mitigate risks. Moving forward, collaborative efforts, informed policies, and sustainable investments will be key in building resilience and sustainability in the face of climate change.




[1] Systemic Risk Buffers: Regulatory capital requirements aimed at bolstering banks’ resilience to systemic crises, reducing the likelihood and severity of financial instability by enhancing capital adequacy during stress periods.

[2] Risk Concentration Limits: Regulatory measures restricting banks’ exposure to specific risks, such as credit, market, or liquidity risk, to prevent excessive concentration in any single counterparty, sector, or asset class, thereby promoting diversification and enhancing financial stability.


An Article by Ruben De Gieter – Consultant at DynaFin.