Climate Related Financial Risks – “To Manage or NOT to is NOT the question – the “HOW To” is!!

At the outset I want to make it clear that this article is NOT about Climate Policy, it is not about climate change mitigation or adoption measures, it is not about the differing views geographical or geopolitical on its relevance, it is not about the ideological debates on what each stakeholder must do.

It is about REAL impact of Climate Related Financial Risks on both the Balance Sheet and P & L of Financial Services firms. It is about the newest set of connected risks that are affecting the Investment and Loan portfolios of banks. “Climate risk, while deeply linked to the wider conversations on climate change, is a distinct and critical subset.”

With my banker’s lens on, I see that with all the surrounding noise, the required focus on the climate related financial risks is getting diffused. These risks that are new and opaque if not well-managed, in a timely manner could create correlated impact and get magnified as they propagate through the system.

Like I said it is real, and it is here. Banks need a focused and objective approach, not because the regulators or regulations demand it, but because of how it could impact their books. A look at a few pointers.

• While banks are at various levels of maturity of assessment, there is a potential of underestimating the actual impact. A research report (referred by Green Central Banking article ) points out that Financial institutions , could be underestimating investor losses from physical climate risk by as much as 70%. With Mexico as the use case, they highlight that if tail risks like cyclones or floods are added, the number could further jump to 82%. While the percentage is unsettling, the indicator highlights the fact that financial institutions are in the early learning phase of estimating climate related financial risks and therefore could be inaccurate.
• An EY report quotes that in 2024, US$417 billion direct economic costs from natural disasters globally; 63% of which were uninsured. This brings out another facet of a risk factor that needs to be consciously factored in both the assessment and monitoring – The insurability.  The risk of not just the insured firm but also the small and medium insurance firms themselves disappearing from the horizon is a likely scenario.
• The report goes on to state that “some banks in the UK and Europe have disclosed a specific amount in their ECL (Expected Credit Losses) estimates, while others indicated that the climate risk was included in the estimate of ECL without any quantification.” This aspect highlights the potential of incorrect understanding and reflection of actual risk.
• As  Governor of Reserve Bank of India calls out, “These risks include losses from credit portfolio due to extreme climate events or natural disasters (physical risks) and loss in value of collaterals due to stranded assets (transition risks); losses from investments; and operational losses.”  Focus here is not just the primary asset but also the collaterals are vulnerable which financial services firms need to be cognizant of.
• Speaking of Climate related vulnerabilities, FSB highlights their impact on almost all classes of risks , credit, market, liquidity, underwriting and other risks. Credit risk arising from concerns about the ability of counterparties affected by climate shocks to meet their obligations (e.g., direct damages from physical risks affecting borrowers’ capacity to repay and the value of their collateral or decrease in firms’ profitability due to sharp changes in consumer preferences or sudden and sizeable price changes in transition-sensitive sectors due to technological innovation).

The undisputable fact is that climate change is a financial risk and needs to be managed as such. Aligning businesses with plans of managing climate change risks like physical, transition, and liability risks, for both their own operations and customer businesses they finance is non-trivial. The challenges like data and skills availability, standardization across taxonomy and regulations, Models and Stress tests, asymmetric expectations from banks across geographies are material, and I am not undermining any of these. The aspect I highlight here  is the urgent need to cancel the surround sound and focus on managing climate related financial risk, as the umbrella risk class that can impact almost all other risk classes. Effective management of these risks not only reduces the downside but also provides an opportunity of riding the wave for sustainable growth of the bank.

References

Sanjay Malhotra – BIS, Central Bank Speech – 19^th March 2025

Financial Stability Board - Assessment of Climate-related Vulnerabilities Analytical framework and toolkit - 16 January 2025

Climate Change Risk Management in Banks – The Next Paradigm – Saloni P Ramakrishna, De Gruyter Publishing