Navigating climate risks: 3 strategies for building resilient financial institutions
Extreme weather events and other climate risks should feature in financial institutions' risk management process. Image: NOAA
- Climate risks can affect business performance through asset damage, operational disruptions and reduced cash flows, ultimately impacting the ability to repay debt and company valuation.
- Financial institutions must manage climate risks as a step towards transitioning to a low-carbon portfolio.
- They can safeguard against losses and capitalize on opportunities by integrating climate risks into risk management frameworks.
Scientific evidence shows that climate change is getting worse, with higher levels of carbon in the air causing more frequent and severe weather events. Additionally, there are risks associated with the transition to a low-carbon economy.
These changes threaten existing assets and businesses, causing serious economic problems. According to the Potsdam Institute, climate-related impacts could reduce global income by 19% over the next 25 years, amounting to $38 trillion in annual losses by 2050. In comparison, the COVID-19 pandemic shrunk global gross domestic product (GDP) by 3% over two years.
The Asia-Pacific region is particularly vulnerable, with 26% of its GDP at risk due to rising temperatures. The World Meteorological Organization labelled 2023 the warmest year in history, while 2024 has been just as warm. Regions across the globe have witnessed heat waves, droughts and deficient rainfall, impacting output, productivity and livelihoods.
These economic impacts translate into risks for businesses and financial institutions. Climate risks can affect business performance through asset damage, operational disruptions and reduced cash flows, ultimately impacting the ability to repay debt and company valuation. For example, a 1% increase in typhoon damage in the Philippines led to a 2.3% rise in non-performing loans, jeopardizing systemic financial stability. Hence, financial institutions must manage climate risks as a step towards transitioning to a low-carbon portfolio.
Besides market forces, regulatory pressures are also increasing. Various regions, including the United Kingdom, European Union (EU), Singapore, Malaysia and New Zealand, are requiring financial institutions to disclose their climate risks and opportunities. For example, the Reserve Bank of New Zealand’s 2023 climate stress tests showed potential impacts on bank profitability and risk-weighted assets. As a result, banks are working to improve their climate risk management.
Therefore, financial institutions need effective climate risk management to safeguard against future losses and stay ahead of evolving regulations, focusing on three critical elements: risk identification, measurement and integration.
Risk identification
Climate risk identification includes these key approaches:
- Sector and location analysis using portfolio exposure and climate hazard data, often through maps, helps identify vulnerable areas and risk hot spots. This analysis also considers these regions’ ability to adapt, reducing their vulnerability.
- Climate materiality mapping assesses key risk factors based on their impact and likelihood of affecting business decisions. Using a balanced scorecard framework improves this process, helping to identify important business elements that could be most affected by climate risks.
- The green asset ratio shows how much a financial institution’s loans and investments go to “green” economic activities. It highlights the potential risk of moving to a low-carbon economy. A lower green asset ratio means that the financial institution might be more affected by policy, technology or market changes to reduce carbon emissions.
- Estimating financed emissions caused by lending or investment decisions helps set a baseline for assessing climate risk and guiding efforts to reduce carbon emissions.
Risk measurement
Climate risk measurement encompasses physical and transition risk assessments including the following dimensions, respectively.
Physical risk assessment
- Hazard: Identifying extreme weather events impacting specific regions.
- Vulnerability: Measuring business sensitivity to these hazards in terms of severity and frequency of risk events.
- Exposure: Assessing the extent of asset, workforce and resource impact.
Transition risk assessment
- Carbon footprint/financed emissions: Establishing a baseline for risk mitigation and driving investments towards lower-carbon alternatives.
- Sector and location analysis: Identifying hotspots affected by policy, technology and market shifts.
- Carbon price impact: Assessing how potential carbon pricing could impact the finances of other parties involved. A carbon price could hurt counterparties’ finances.
A probability-based scoring system helps determine physical and transition risks, respectively, at the borrower or investee level.
Additionally, climate scenario analysis is also used in a risk assessment to assess how different levels of global warming could impact economies, business drivers and financial institutions’ risk ratios.
Risk integration
Integrating climate risks into existing risk management processes involves:
- Enterprise risk management: Establishing an early warning system to flag climate risks and assess their impact on existing risk categories and policies.
- Risk appetite framework: Using clear guidelines to evaluate financing activities in line with a financial institution’s climate strategy. This includes such strategies as avoiding certain investments, selling off assets, or setting limits on loans to control exposure on the balance sheet and determine pricing based on climate risk.
- Conventional risks: Incorporating climate factors into existing risk management processes, evaluation criteria and internal ratings to address impacts on cashflows, debt serviceability, asset pricing, liquidity and operational efficiency.
- Sustainability disclosures: Tracking climate risks transparently and accurately, using standards like those from the Task Force on Climate-related Financial Disclosures and the International Accounting Standards Board –International Financial Reporting Standard IFRS S2 – serves as a scorecard for monitoring progress in strategy formation.
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In sum, effective climate risk management is essential for financial institutions transitioning to low-carbon portfolios. By improving risk identification, assessment, and integration, financial institutions can enhance decision-making and strategies, build institutional resilience and capitalize on emerging opportunities through sustainable lending and investing.
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