Managing climate-related threats in financial organizations

The financial sector is grappling with the incomplete understanding of climate-related risks, as highlighted by experts from various institutions. This is a critical issue, given the growing materiality and impact of these risks on financial stability.

Isabella Frymoyer, Programme Coordinator at the Sustainable Policy Institute at OMFIF, underscores the responsibility of the financial sector to transition away from nature-negative flows and towards activities that mitigate climate change and build resilience. Sem Housen and Emily Dahl from the United Nations Environment Programme Finance Initiative share this view.

The good news is that financial institutions have options to support the transition. Central banks can adjust regulatory frameworks, collect more comprehensive data, and stress test. OMFIF's Sustainable Policy Institute Journal's July edition delves into the approach of the financial sector towards climate risk, focusing on opportunities, challenges, nature risk, and scenario modelling.

However, challenges persist. According to William Attwell at Sustainable Fitch, many banks still have a long way to go to provide the comprehensive climate-related information expected by market stakeholders and supervisors. Climate risks mainly come from nature-focused impacts of climate change such as biodiversity loss, extreme weather, and ecosystem disruption. Linda-Eling Lee from MSCI Sustainability Institute explores worst-case physical risks, emphasizing the need for a broader understanding of environmental tipping points.

Determining the financial impacts of climate change relies on this understanding. Lydia Marsden from University College London stresses the need for policy-makers to better understand nature risk, as ecosystem tipping points have far-reaching implications across regions and sectors. Sharon Asaf and Sebastian Werner at Citi highlight the relationship between scientific and financial modelling, pointing out the limitations in scientific models that lead to struggles to precisely replicate climate impacts, particularly in the short term.

Nature risk remains a particular challenge, with banks lagging in fully incorporating these risks compared to climate risks. Udaibir Das from the National Council of Applied Economic Research notes that the most serious constraint on climate finance for developing countries is a mismatch between finance structure and climate action.

The rapidly evolving regulatory landscape, especially around ESG mandates and Basel III implementations, complicates risk management. The adoption of AI introduces innovation but also concerns related to model transparency and systemic bias when applied to risk modeling.

In summary, key trends include growing but uneven integration of climate and nature risks in financial risk frameworks, accelerated regulatory and data demands, and emerging technological tools like AI in modeling. Major challenges involve fully capturing nature-related risks, closing gaps in scenario analysis and capital planning, managing regulatory divergence, ensuring data quality and model transparency, and addressing systemic risks amplified by climate shocks and transition pathways.

As the global economy enters a new era of opportunity in transition finance, understanding the risk associated with environmental impacts, particularly as the financial industry transitions to net zero, will remain essential to easing stress on the global financial system. Paul Hiebert from the European Central Bank warns that climate shocks could lead to immeasurable financial loss. David Carlin, D. A. Carlin and Company, suggests that this is an age of recalibration for sustainability regulations, and firms should prepare for changes. Marcus Pratsch from DZ BANK writes that nature-positive solutions must remain central to the net-zero transition as the importance of biodiversity in capital markets is increased.

Isabella Frymoyer emphasizes the financial sector's responsibility to transition from nature-negative flows to activities that mitigate climate change and build resilience.
Sem Housen and Emily Dahl from the United Nations Environment Programme Finance Initiative share the same view as Isabella Frymoyer.
Financial institutions have options to support the transition, such as adjusting regulatory frameworks, collecting comprehensive data, and stress testing.
Climate risks primarily come from nature-focused impacts of climate change, including biodiversity loss, extreme weather, and ecosystem disruption.
Lydia Marsden stresses the need for policy-makers to better understand nature risk, as ecosystem tipping points have far-reaching implications across regions and sectors.
Nature risk remains a significant challenge, with banks lagging in fully incorporating these risks compared to climate risks, and the most serious constraint on climate finance for developing countries being a mismatch between finance structure and climate action.
The adoption of AI introduces innovation but also concerns related to model transparency and systemic bias when applied to risk modeling.
Understanding the risk associated with environmental impacts, particularly as the financial industry transitions to net zero, will remain essential in easing stress on the global financial system, aswarned by Paul Hiebert from the European Central Bank, and suggested by David Carlin that this is an age of recalibration for sustainability regulations.