Climate change risks affect numerous industry sectors, such as banks, credit unions, mortgage lenders, insurers, investment houses and consumer finance companies. An extreme weather event could lead to widespread bank failures in regions reliant on energy or agriculture for their livelihood.
Financial institutions can reduce both physical and transition risks by including climate considerations in their monitoring and risk management processes, something some have already begun doing.
Physical Risks
Most people associate climate change risks with physical damages caused by more frequent and severe weather events, but these risks have direct ramifications for financial stability as they could increase insurance claims, bank loan defaults or writedowns and writedowns of investments held by investors. They could also cause reduced economic output that reduces household incomes and wealth as well as decreased access to capital resulting in migration or business failures.
Due to global warming, some nations have implemented policies designed to lower greenhouse gas emissions and mitigate climate change’s effects. Such strategies include carbon taxes, energy-efficiency standards for buildings and vehicles, as well as phase-out of fossil fuels before greener alternatives become available. While such changes might help combat global warming’s effects on their economies, such changes can have serious ramifications on economic distributional issues: raising risk of stranded assets due to regulations/technology shifts while restricting growth in sectors dependent on fossil fuels.
Climate-related environmental risks can cause disruptions in the supply chains of many financial institutions and increase operating costs, which in turn are passed on to customers via higher insurance premiums or loan default rates. Furthermore, climate damages to infrastructure can lead to additional repair and maintenance costs that disproportionately burden financially vulnerable households and businesses.
Banks and other financial institutions are responding to growing customer interest in investing opportunities that support sustainability, with many investors factoring sustainability considerations into their investment decisions. However, quantifying and modeling climate risks presents banks with several significant challenges. Most don’t have the resources or expertise necessary to assess these risks effectively while the data needed to model them are limited and incomplete. Mortgage loans and derivatives involve long contract horizons that make climate risks difficult to measure in stress tests, making their impacts hard to recognize immediately. Still, many Regulated Organizations are making progress in building capacity to manage these risks by including climate considerations into limits and sector exclusion policies.
Transition Risks
Assessing climate change risks is an integral component of managing them effectively for banks, insurance companies and financial supervisors. To this end, these regulated entities and supervisors require tools that enable them to identify, measure and mitigate those risks within their operations and balance sheets as well as assess resilience within the system itself.
Regulated entities should incorporate emerging risks into their credit rating processes, risk management frameworks and strategic plans. For instance, they must consider how increased vulnerability to physical risks such as sea level rise or extreme weather events affects customers’ ability to repay loans and debts.
Financial institutions and investors must assess the effects of transition risks on their loan portfolios, investments and other assets as the shift toward a low-carbon economy requires global policy action, technological innovation, more sustainable finance practices and substantial socio-economic changes – mispricing these risks could expose financial institutions and investors to sudden and potentially severe losses.
As we transition toward a low-carbon economy, significant changes will need to be implemented across energy systems and activities that produce greenhouse gases – as well as across other activities in general – within our economy. It can be challenging for businesses to plan for such changes if public policy and customer demand remain uncertain, which could lead them to underinvest in low-emitting activities while overspending on high-emitting ones which may become less profitable under an emissions reduction regime.
Therefore, the NCUA is seeking input from federally insured credit unions (FICUs) on how they can enhance their abilities to identify and assess climate and natural disaster risks. Furthermore, its Board would welcome hearing about experiences or views from stakeholders such as central banks on these matters. Feedback given will allow it to develop new capabilities to better comprehend potential effects climate and natural disaster risks have on national banks and federal savings associations, including potential effects that threaten safety and soundness of national banks or federal savings associations. Its Board will carefully consider all comments before making its approach decision on this important matter.
Contagion Risks
Climate change will have an enormous effect on financial institutions both directly and indirectly, with direct consequences including higher insurance claims and credit losses; indirect effects include disruptions in global finance that impede service to clients while supporting economic growth; natural disasters like hurricanes or wildfires can disrupt transportation networks leading to supply chain issues that increase consumer prices, while drought can reduce agricultural production leading to decreased food supplies affecting both consumers and financial markets.
These risks will become magnified during the transition to a low-carbon economy. Rapid changes in regulations, technology and consumer and market preferences could threaten emissions-intensive industries economically unviable and “strand them”. Such an event could spread through multiple financial institutions leading them to reduce lending which in turn might depress economic activity while simultaneously raising risks in general.
Banks must incorporate climate considerations into their risk management and business strategies in order to be effective. To do so successfully, this integration should be driven by an organized strategy with a comprehensive approach for handling climate risks such as potential downsides as well as revenue generation opportunities. This requires creating governance frameworks specific to climate risk management; employing experienced senior personnel; engaging clients, industries sectors and regulatory authorities on ongoing dialogue regarding this subject matter; etc.
Step one should be to identify and quantify the most material climate-related risks to the financial sector and their likelihood of realization, using scenario planning with standard methodologies. Step two should include conducting regular monitoring processes in order to detect new climate risks that emerge over time.
Many banks are including climate-related considerations into their risk management and capital allocation decisions, for instance by factoring climate-related restrictions into limits for sectors like coal mining or by restricting exposure to regions and industries that could be more vulnerable.
Financial Risks
Banks face climate change risks because of their potential to cause significant financial harms, including disruptions in business operations that result in lost revenue or increased expenses, financing a transition away from fossil fuels, loss in value to assets such as real estate or infrastructure as well as new liabilities such as climate-related insurance claims or changes in regulatory regimes. Climate change risks represent one such financial threat.
Climate change risks are mitigated through financial markets, with their effects having ripple effects that are amplified through asset pricing. A survey conducted among financial professionals indicates that climate risks associated with low-carbon futures are underevaluated in asset prices – this increases the potential for disorderly price adjustments which could have serious systemic ramifications for an economy and its flow of goods and services.
Financial risks relating to climate change can be assessed using similar methodologies as those used to measure and manage other forms of risk, but will likely require more complex analysis due to uncertainty regarding its effects on global weather patterns, economic and financial sectors, individual institutions and policy responses. A holistic approach that considers both economic and financial dimensions must also take into account every possible scenario that might present both opportunities and threats resulting from climate change.
Banks looking to become effective managers of climate change must first identify and develop the processes, methodologies, and tools they will require in order to do so effectively. This involves embedding climate factors into risk and credit frameworks (for instance by using climate-centric counterparty scoring), conducting stress tests on portfolios impacted by climate change impacts, gaining greater insight into impacts from those impacts as well as identifying data gaps; in addition, banks should focus on enablers such as building skills in this area or investing in technology to facilitate analysis.
