Mitigating the financial impacts of climate-related risks

Thu 01 Feb 2024

The integration of environmental, social and governance (ESG) considerations into strategic planning is increasingly becoming a common practice among financial services firms. However, climate-related risks can also serve as drivers of financial risk for institutions. These risks can manifest through various transmission channels, translating climate and environmental (C&E) risks into more conventional categories such as operational, credit or market risk. It means financial institutions are responsible for managing these risk drivers by incorporating them into their risk management frameworks and strategies. 

According to the latest Mazars’ survey, Sustainability practices stocktake: How banks and insurers have progressed, the inclusion of C&E risk drivers into traditional risk management practices is gaining traction. While the survey highlights variations in approach based on geographical location, over 60% of surveyed banks have started incorporating C&E risk drivers into business continuity planning and market risk metrics. 

However, identifying and understanding the relevant risk drivers associated with climate-related physical and transition risks is crucial for effective risk management. It involves developing a process to determine which risk drivers could have a material impact on risk profile and operations.

Identifying and understanding relevant risk drivers

The impacts of physical and transition risk drivers can affect economic activities, which in turn influence the financial system. These causal chains, known as transmission channels, explain how climate risk drivers give rise to financial risks. Such channels can operate directly through microeconomic impacts, such as lower corporate profitability or asset devaluation and indirectly through macro-financial changes. As a result, climate risk drivers can impact various financial risk categories through these transmission channels, including credit, operational, market and liquidity risks. 

One specific area where the impact of climate risks is becoming increasingly important is collateral valuation. Indeed, including climate risks in the valuation report for immovable property collateral may become a minimum requirement. This is because climate risks can affect the loss given default (LGD) and expected credit losses (ECL). These changes in collateral valuation can subsequently impact how credit risks associated with lenders are computed. 

Integration of climate-related financial risks

Progress is underway in comprehensively integrating climate-related financial risks into existing risk management processes, including banks’ risk appetite and the impact on financial risk parameters such as probability of default (PD), LGD and risk-weighted assets (RWA). For example, climate risk processes are being incorporated into operational and credit risk frameworks, with stress testing focusing on the percentage of assets or collateral impacted by physical risks.

Like the banking sector, the insurance sector faces climate-related risks and is susceptible to climate stress testing. Studies indicate that insurance companies could experience significant losses under disorderly transitions scenarios. For example, EU insurers’ equity holdings in climate policy-vulnerable industries could decline up to 15% under a disorderly scenario. On the liability side, climate-related risks are also expected to have a notable impact, with the loss ratio for property insurance firms reaching 30% of previously collected gross written premiums. 

Equally, banks are conducting various scenarios and stress tests to assess the impact of climate change on their portfolios, covering credit risk, market risk and operational risk. For instance, in the ECB’s 2022 climate scenario testing, banks projected that overall credit losses in the non-financial corporation (NFC) loan and mortgage portfolio would be 10% higher under a disorderly transition by 2050. In a “hothouse world” scenario, the increase would be 13%. 

An ongoing process

Looking ahead, climate stress testing should consider climate, macroeconomic, sector and company-specific factors, differing from traditional stress testing tools and credit risk models. It is an ongoing process and, as numerous climate stress tests approaches are established, they are expected to play a significant role in refining methodologies, developing comparable exercises and addressing data gaps. 

The banking and insurance sectors hold significant influence over the transition to a low-carbon economy. As we move forward, taking a more holistic approach to identifying and understanding climate risk drivers and incorporating them into risk management frameworks and strategies is essential.