What is Climate Risk in Finance? Why Is It Important?

by | Mar 19, 2024 | Climate Risk | 0 comments

Welcome to a primer on climate risk in the financial industry. This blog series will guide you through some initial industry research into managing climate risk so that you understand what is at stake for your institution and how to get started with measuring and mitigating this emerging source of risk.

What is Climate Risk in Finance?

Climate-related financial risks, including transition and physical risks, can manifest within traditional risk areas including credit, market, liquidity, operational, and legal risks. To effectively manage climate risk, banks must integrate it into their existing workflows as a fundamental aspect of overall risk assessment and management.

Financial Institutions (FIs) in much of the developed world have finally been placed under regulation with respect to risks arising from climate change. These regulations broadly speak to the need for FIs to understand how climate change may present emerging risk to business as usual, incorporate it into risk appetites and other frameworks, and perform scenario analysis for future planning.

Risk analysis has always been an evolution from the identification of a new phenomenon or opportunity to a judgment-based override of a business-as-usual (BAU) process. New data sources or tweaks to methodology are sought out and identified and, before long, the full consideration of the phenomenon or opportunity is baked into the model’s next generation, thereby becoming part of the BAU process.

Although climate risk is a relatively new area of concern, credit risk specialists can rely on this normal evolution. We are at the beginning of the climate risk journey and up against a global issue that can be overwhelming. You may also be unsure what data is available and may not have in-house expertise in order to use new data sources. Hopefully, though, you will start to see that incorporating climate risk into your standard risk measurement practices isn’t unprecedented.

Examples of climate-related risk:

  1. Extreme weather events
  2. Prolonged heatwaves
  3. Rising sea levels
  4. Coastal erosion
  5. Biodiversity depletion.

These events can significantly impact the financial stability of banks by affecting the assets they hold or the borrowers’ ability to repay loans.  

Three components of climate risk:

  1. Hazard
  2. Vulnerability
  3. Exposure

This definition acknowledges the dynamic nature of climate risk in finance, where each element can change over time due to climatic or socio-economic factors. These changes, whether natural, unintended, or deliberate, affect the variables and time frames involved.

We want to help your financial institution get started on this paradigm shift through this series of blog posts. In this first installment, we’re going to tackle the big question at an introductory level: What is climate risk, and why is it important? We will follow that with a discussion of the key players and what they do, and then lay out steps a Financial Institution can take to begin addressing climate risk.

Defining Climate-Related Risk in Finance

“Climate risk” in finance is the risk presented to the financial industry by climate change. In most literature, climate risk is broken down into transition risk and physical risk.

Transition risk is the risk to the financial industry related to the transition of the economy away from industries that have been found to exacerbate the levels of greenhouse gases in the atmosphere.

Physical risks are those risks that arise from the effects of climate change on the environment. Physical risks can be subdivided into:

  1. Financial risk arising from the increasing frequency and severity of acute weather events like storms, flooding, heatwaves, and wildfires; and
  2. Financial risk arising from the chronic effects of climate change on the environment such as drought, shoreline erosion, and changing growing conditions.

Many of the myriad challenges presented to consumers by climate change are, by extension, challenges to the financial industry. So, it would be a useful exercise to think through the challenge that consumers might face, as illustrated in the figure below (click to enlarge).

What is climate risk in finance

According to a nearly unanimous chorus of climate scientists, the chances that climate predictions turn out to be true are undeniably large and new data further supports the predictions. This means that climate-related physical risks are all but certain to continue and worsen, causing many serious problems for society. And, in truth, that could be the biggest issue: the impact of climate change on society.

The economy supports society. The environment supports the economy. The link that needs to break is that the environment can no longer be exploited for the sake of supporting the economy or we can forget about all three – economy, environment, and society. So, achieving the economic transition to a less climate-intensive economy is key. Done too fast, there will be severe damage done to the financial industry, many other industries, the economy, and by extension, society. Done too slow, or not done at all, irreparable damage will be done to the environment.

Why Climate Risk Analysis is Important

There are many reasons why analyzing the potential impact of climate change on your FI’s portfolio is important. Here are a few of them:

  • The United Nations collectively, the governments of 200 countries independently, climate scientists en masse, central banks, and regulators say it’s important. It isn’t up to the bank to believe or disbelieve in climate science. Banks don’t even need to be convinced that humans are the cause of climate change. Banks are mandated to care through regulation.
  • Drawing a parallel to Pascal’s Wager, and with a purely existential view of the climate risk, paying the matter its due diligence is the least we, as a society, can do. It is a prudent action, which is right in line with how risk management professionals think. Paying lip service is arguably worse than outright refusal. Caring, and caring enough, to do a great job are of utmost importance.

A table showing the possible outcomes of 1., acting or 2,. delaying or refusing action in the event that climate predictions turn out to be true.

  • Because the financial industry underpins nearly all businesses, impacts on that industry can have a cascading effect on the economy. The financial system has a key role to play in the transformation of the economy. Its influence in helping us transition to a net-zero emissions economy is exerted through the financial system’s consumer and commercial lending practices and the accurate measurement of climate risk.

More Reasons Why Climate Risk Analysis is Important

  • Some economic sectors in some regions will experience a boost from the transition of the economy and/or the chronic effects of climate change. Those who may experience such a boost might enjoy a reduction in the risk they present to lenders and should be able to negotiate lending terms that reflect this reduced risk.
  • Both physical and transition effects of climate change may cause disproportionate harm to certain segments of the population, including those segments that have been historically marginalized. Therefore, keep in mind that some suspected climate risk impacts might present themselves nonlinearly with respect to macroeconomic variables like income and poverty rates.

Now you have some background on the issue, laced with fact and opinion.

Regulators have been asking you, “how much of your portfolio is at risk due to climate change?” You are being asked to stress test how your portfolio reacts to a localized physical climate event. Since risks related to climate change are expected to materialize over decades, you may think about the combination of the effects of climate change with recessions, pandemics, mass migration, and/or geopolitical tensions.

What may be different for you this time is that there isn’t necessarily a roadmap laid out for you. Most risk professionals assigned this project will be embarking on something that may be completely new or at least novel to them and their institution. The next post in this series will introduce you to some of the key players and useful resources that are available to help you and your financial institution start moving forward.

Joey Doyle, business analytics consultant with FRG, has more than 15 years of experience in risk analysis. With a background in pure mathematics and education, Joey tends to build analytics from the ground up using first principles and innovative thinking. His experience includes modelling, strategy, provision and stress testing analytics.