Every day, the threat of climate change becomes more evident as it deeply impacts our environmental, socioeconomic, and political spheres. For every 1°C increase in global temperature, there is a 12% decline in global GDP,[1] with climate-related impacts potentially resulting in $38 trillion annual losses by 2050.[2] The financial sector is not immune to these challenges; climate change poses significant risks to the stability and profitability of financial institutions. As physical impacts from environmental extreme events and regulatory pressures escalate, managing climate risks has become imperative for financial institutions. However, the topic of climate risk management can seem puzzling and daunting to many in the financial sector. This article aims to clarify the complexity of climate risks and provide three key strategies to mitigate them, along with guidance materials and tools that financial institutions can utilize.
Understanding Climate Risks
Before diving into the key procedures for managing climate risks, it is crucial to understand what climate risks are and why they must be managed. Climate-related financial risks can originate from two types of risks: physical risks and transition risks.
Figure 1. Definitions of climate risks[3]
Both types of climate risks can have negative effects on the financial sector, by affecting a bank’s operation and clients, and impacting their financial services and products. For instance, acute physical climate risks can damage the physical collaterals backing loans, which in turn enhances credit risks and impacts the bank’s profitability.[4] These acute risks can also disrupt a financial institution’s operations by damaging IT infrastructure; for example, a heavy storm can affect access to internet and IT systems interfering with business activities.[5] Moreover, climate risks impact on a bank’s portfolio also depend on the type of sectors it lends to. Sectors that heavily rely on natural resources are particularly vulnerable to extreme events, such as agriculture and fisheries, metals and mining, and real estate.[6] On the other hand, industries such as coal mining and oil and gas face high exposure to transition risks, where climate policies like green taxes can impact their profitability and increase credit risk for financial institutions.[7] In this way, climate risks are also associated with credit, liquidity, and legal risks faced by financial institutions.
Identify, Measure, and Manage
There is no one-size-fits-all approach to managing climate risks, as these risks are specific to the environmental, economic, and political context of each financial institution. However, there are three key strategies that financial institutions can implement and adapt to their circumstances: risk identification, measurement and management.
Figure 2. Strategies for Climate Risk Management
- Climate Risk Identification
Financial institutions can identify climate risks by assessing portfolio exposure, conducting literature review, using risk indices, and analyzing climate hazard data, such as geographic information systems (see Annex). Specifically, physical risks can be identified by considering three components:
- Vulnerability: the sensitivity and propensity to harm.
- Hazard: the occurrence of climate-related physical events and impacts.
- Exposure: the people, livelihoods, species or ecosystems that could be adversely affected.[8]
For transition risks, estimating financed emissions is another way to identify potential risks associated with the transition to a low-carbon economy.[9] In addition, there are two types of transition hazards to consider:
- Policy: changes in policy and regulations, such as carbon pricing.
- Technology: changes in technology availability and costs, such as costs of renewable energy technologies or fossil fuel extraction.[10]
- Climate Risk Measurement
Once climate risks have been identified, financial institutions can measure their potential impacts and expected losses. Climate scenario analysis is an effective tool for quantifying potential exposures to climate risks.[11] These scenarios are plausible representations of future impacts of climate change and should be designed to be plausible, distinctive, consistent, relevant and challenging.[12] Based on these climate scenarios, financial institutions can estimate both direct and indirect impacts associated with each scenario.[13]
- Climate Risk Management
Effective climate risk management involves integrating climate risk considerations into existing risk management procedures. Since climate risks impact credit risks, financial institutions should incorporate climate risks into their Environmental and Social Management Systems (ESMS) as well as into their risk appetite and credit strategy.[14] Moreover, establishing climate governance within the institution is another critical component in climate risk management. It involves assigning specific roles responsible for managing climate risks and ensuring board-level oversight of strategic climate risk management.[15] Additionally, climate risk management should also be included in reporting procedures; financial institutions can adhere to the Task Force on Climate-related Financial Disclosures (TCFD) standards to disclose their exposures to climate risks.
Embracing Climate-Related Opportunities
While managing climate risks can be challenging for financial institutions, it also opens the door to new opportunities, particularly in relation to green financing. Climate change is not just a threat, it can also be a catalyst for innovation and growth in the financial sector. By effectively managing climate risks, financial institutions can position themselves to meet new financial needs from their clients, including private companies and governments, and the increasing demand for financing adaptation and mitigation measures.[16] Moreover, climate risk management aligns and supports a bank’s green agenda, enabling financial institutions to identify and finance investment opportunities in clients who are implementing innovative and resilient solutions.[17] In this way, managing climate risks is not only about mitigating potential losses but also about seizing opportunities that contribute to a financial institution’s long-term resilience and profitability.
—
Natalia Velázquez is an Analyst at HPL, graduated with a Bachelor’s Degree in International Relations from the Instituto Tecnológico Autónomo de México (ITAM). In HPL, she has supported 19 consultancy projects related to sustainable finance research, market guidance development, and the preparation and structuring of thematic bonds for development banks, commercial banks, and corporates in LAC. Natalia has also contributed to the execution of sustainable finance studies for multilateral development banks and international organizations.
—
References
[1] Michael Purton for World Economic Forum (2024). Climate crisis costs the world 12% in GDP for every 1°C temperature rise, and other nature and climate stories you need to read this week. Available here.
[2] Namita Vikas for World Economic Forum (2024). Navigating climate risks: 3 strategies for building resilient financial institutions. Available here.
[3] Network for Greening the Financial System (NGFS) (2022). Physical Climate Risk Assessment: Practical Lessons for the Development of Climate Scenarios with Extreme Weather Events from Emerging Markets and Developing Economies. Available here.
[4] Peterson K. Ozili (2020). Effect of Climate Change on Financial Institutions and the Financial System. Available here.
[5] Ibid.
[6] Acclimatise for UNEP FI (2020). Charting a New Climate. State-of-the-art tools and data for banks to assess credit risks and opportunities from physical climate change impacts. Available here.
[7] John Colas, Ilya Khaykin, Alban Pyanet for Oliver Wyman (2019). Climate Change Managing A New Financial Risk. Available here.
[8] Acclimatise for UNEP FI (2020). Charting a New Climate. State-of-the-art tools and data for banks to assess credit risks and opportunities from physical climate change impacts. Available here.
[9] Namita Vikas for World Economic Forum (2024). Navigating climate risks: 3 strategies for building resilient financial institutions. Available here.
[10] Paul Smith for UNEP FI (2021). The Climate Risk Landscape. A comprehensive overview of climate risk assessment methodologies. Available here.
[11] Network for Greening the Financial System (NGFS) (2022). Physical Climate Risk Assessment: Practical Lessons for the Development of Climate Scenarios with Extreme Weather Events from Emerging Markets and Developing Economies. Available here.
[12] Ibid.
[13] Ibid.
[14] Joseba Eceiza, Holger Harreis, Daniel Härtl, and Simona Viscardi for McKinsey & Company (2020). Banking imperatives for managing climate risk. Available here.
[15] Ibid.
[16] Acclimatise for UNEP FI (2020). Charting a New Climate. State-of-the-art tools and data for banks to assess credit risks and opportunities from physical climate change impacts. Available here.
[17] Ibid.
—
Annex
Table 1. Examples of data sets and tools for physical and transition risks assessments
| Data set/Tool | Service Provider | Description |
|---|---|---|
| Physical Climate Risks | ||
| Aqueduct Floods | World Resources Institute (WRI) | Aqueduct’s tools use open-source, peer reviewed data to map water risks such as floods, droughts and stress. Aqueduct Floods identifies coastal and riverine flood risks, and analyzes the costs and benefits of investing in flood protection. |
| ThinkHazard! | World Bank Group | ThinkHazard! provides an overview of hazards for a given location that should be considered in the design and implementation of a project to promote disaster and climate resilience. The tool indicates the likelihood of different natural hazards affecting project areas (very low, low, medium and high) and gives guidance on how to reduce the impacts of these hazards and where to find information. |
| UNCCD Drought Risk Assessment Visualization Tool | United Nations Convention to Combat Desertification (UNCCD) | The drought risk assessment in this tool is applicable for 2000-2018, and uses a global-scale top-down data-driven approach that is consistent and applicable to all regions of the world. |
| Aqueduct Water Risk Atlas | World Resources Institute (WRI) | Aqueduct’s tools use open-source, peer reviewed data to map water risks such as floods, droughts and stress. Aqueduct Water Risk Atlas maps and analyzes current and future water risks across locations. |
| Climate Diagnostic | Willis Towers Watson | Climate Diagnostic allows users to understand both the impact of acute physical climate risks and chronic physical climate risks. |
| ND GAIN Index | University of Notre Dame | The Notre Dame-Global Adaptation Index (ND-GAIN) Country Index is a free open source index that shows a country’s current vulnerability to climate disruptions. It also assesses a country’s readiness to leverage private and public sector investment for adaptive actions. |
| Global Climate Risk Index | German Watch | The Global Climate Risk Index analyses and ranks to what extent countries and regions have been affected by impacts of climate related extreme weather events. |
| Global Forest Watch | Global Forest Watch & World Resources Institute (WRI) | Global Forest Watch (GFW) is an online platform that provides data and tools for monitoring forests. |
| Physical and Transition Climate Risks | ||
| Climate Impact Explorer | Climate Analytics | The Climate Impact Explorer provides projections for future climate impacts at different warming levels and for several policy-relevant greenhouse gas emission scenarios. Several climate or climate impact indicators can be selected. The Climate Impact Explorer shows maps and graphs illustrating the projected changes for several global warming levels and how they will play out over time according to these emission scenarios. |
| Climate Change Knowledge Portal (CCKP) | World Bank Group | The Climate Change Knowledge Portal (CCKP) provides global data on historical and future climate, vulnerabilities, and impacts. |
| IPCC WGI Interactive Atlas | Intergovernmental Panel on Climate Change (IPCC) | The Interactive Atlas regional information allows for flexible temporal and spatial analyses of trends and changes in key atmospheric and oceanic variables, extreme indices and climatic impact-drivers (CIDs), as obtained from several global and regional observational and model simulated datasets used in the report. |
| PlanetView | Planetrics | Planetrics model the impact of a broad range of physical and transition-related climate risks on financial institutions. |
| UN Biodiversity Lab | UNDP, UNEP, UNEP-WCMC, and CBD Secretariat | With over 400 of the world’s best data layers on nature, climate change, and sustainable development, the UN Biodiversity Lab (UNBL) supports country-led efforts to use national and global spatial data for planning, monitoring, and reporting and to take action for people and the planet. |
| Transition Climate Risks | ||
| Transition Check | United Nations Environment Program – Finance Initiative (UNEP FI) | Transition Check is a tool that takes a scenario-based approach for assessing transition risk and the potential impact of climate change on corporate lending portfolios within an overall framework consistent with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). |
| Climate Credit Analytics | Oliver Wyman & S&P Global Market Intelligence | Through a highly dynamic, sector-specific approach, Climate Credit Analytics enables counterparty- and portfolio-level analysis of climate-related financial and credit risks for thousands of companies across multiple sectors. |
| Climate Change Performance Index | Climate Change Performance Index (CCPI) | The Climate Change Performance Index (CCPI) is an independent monitoring tool for tracking the climate protection performance of 63 countries and the EU. |
| GHG Protocol Carbon Footprint Tools | Greenhouse Gas Protocol | GHG Protocol’s tools enable companies to develop comprehensive and reliable inventories of their GHG emissions. |
| NGFS Climate Scenarios | Network of Central Banks and Supervisors for Greening the Financial System (NGFS) | The NGFS Scenarios have been developed to provide a common starting point for analyzing climate risks to the economy and financial system. The NGFS scenarios have been brought up-to-date with latest economic and climate data, model versions and policy commitments, reflecting new country-level commitments to reach net-zero emissions made until March 2023. |
| Climate Action Tracker | Climate Analytics & NewClimate Institute | The Climate Action Tracker is an independent scientific project that tracks government climate action and measures it against the globally agreed Paris Agreement. CAT quantifies and evaluates climate change mitigation targets, policies and action. CAT further develops sectoral analysis to illustrate required pathways for meeting the global temperature goals. |
Table 2. Additional guidance material for managing physical and transition risks
| Name | Author | Description |
|---|---|---|
| Charting a New Climate | Acclimatise & UNEP FI | This report describes the outputs of the UN Environment Programme Finance Initiative (UNEP FI) Phase II banking pilot which lays out state-of-the-art tools and data for assessment of physical climate-related risks and opportunities by banks. |
| The Climate Risk Landscape | UNEP FI | This report is intended, not to provide a comprehensive guide to scenario analysis and risk assessment, but rather a summary of the key developments of the climate risk assessment landscape since May 2019, including new and updated scenarios, methodological tools, key guidelines, as well as an overview of the changing regulatory landscape and potential developments into 2021. |
| The Climate Risk Tool Landscape | UNEP FI | This report seeks to catalogue the actual experiences that financial users had while piloting different tools and climate-related financial risk assessment methodologies. The detailed case studies include insights into the process, challenges, outputs, and learnings related to using selected climate risk tools. |
| Assessing climate transition risk: methodologies and roles for financial institutions | UNEP FI & PWC | This report highlights the critical nature of retrofits, evaluates existing methodologies for assessing climate risks in real estate portfolios, and explores the roles that various stakeholders play in facilitating the retrofitting process. |
| The climate data challenge: the critical role of open-source and neutral data platforms | UNEP FI & Dataland | The report explores the challenges that companies, including financial institutions, could face in relation to climate data, including data availability, quality, comparability, and timeliness. |
| Managing physical climate-related risks in loan portfolios | UNEP FI & Munich RE | This report offers an in-depth analysis of physical climate risk management. It provides concrete, actionable insights for financial institutions, and serves as a practical guide, presenting a comprehensive overview of current practices, emerging trends, and innovative approaches in managing these risks. |
| The Global GHG Accounting and Reporting Standard Part A: Financed Emissions | PCAF | This document is an update of the Financed Emissions Standard published in 2020, and includes: i) a new methodology for sovereign debt; and ii) guidance on how to measure financed emissions related to GHG emission removals. |
| From Disclosure to Action | UNEP FI | This document provides an updated view on industry good practices regarding climate risk management at all levels of an institution, by presenting survey results to 39 global banks. |