Climate risk in banking: A growing threat and untapped opportunity

Banks have a critically important part to play in tackling the climate crisis. They are owners of a lot of premises that might be impacted by severe weather events but, much more importantly, many of the businesses that that they serve are going to be affected by climate change.

Deloitte says that the banking industry is playing a leading role in addressing the climate crisis. It adds that the actions that banks and their clients take to reach their net-zero commitments will ‘materially transform’ their lending practices.

However, in order for that to happen, banks will need to have better data at their disposal than they do today. The big problem that bank Chief Risk Officers (CROs) have in assessing climate risk at the moment is the lack of reliable data.

Given all the attention that there has been on this topic it appears that bank CROs now realise the importance of climate in their risk analysis. But data remains a problem. According to the EY-IIF Global Bank Risk Management Survey, CROs say climate risk is their top emerging risk over the next five years, according to 96% of CROs surveyed. The same survey reported that climate risk the number one concern of their board of directors.

Physical vs transition risk: Understanding the two main categories

There are two main forms of climate risk that banks have to deal with: physical and transition. They are significantly different but equally important.

Physical risks cover those that impact the premises and operations of a bank, and those of its clients (whose creditworthiness could be adversely affected by climate change), as well as the broader impact on the wider economy. Recent extreme weather events – especially the more frequent occurrence of flash floods and fires – have added to the importance of physical risk.  Physical risks have significant tail risk. They are low-probability events but they entail large, or potentially even devastating, losses.

Physical risks can substantially reduce the value of assets held by banks’ clients. ‘The impact of climate change on economies and businesses tends to be underpriced by markets, despite the fact that there has been a notable rise in both insured and uninsured losses from natural disasters over recent decades,’ says JP Morgan. It also makes the point that the rebuilding required from fires and floods, are often underestimated when all the hidden costs are taken into account. (See chart below).

Source: Munich Re

Transition risks are those that impact a bank’s products and services as a result of the move toward a lower carbon economy. They include the extent to which a bank funds, or has a stake in, companies that are required to lower their emissions in order to meet regulatory requirements. Transitioning to comply with climate requirements can have a considerable impact on some companies’ profitability, especially those involved in the traditional energy sector, including their many suppliers.

Also, some of these companies may well face expensive legal challenges too. There have been about 2,000 legal cases around the globe that have been linked to climate litigation to date, and these are growing. Litigation risk is in some respects a subset of transition risk and is something that banks need to be aware of.

Why banks have underestimated climate risk (and the potential consequences)

The financial industry as a whole, especially the banking sector, is now aware that the threat of climate risk has often been underestimated. S&P state that almost 60% of companies in the S&P 500 (market capitalisation of $18.0 trillion) and more than 40% of companies in the S&P Global 1200 (market capitalisation $27.3 trillion) hold assets at high risk of physical climate change impacts. These companies are many of banks’ biggest clients.

Research from EDHEC, published last year, found that climate risk has been greatly underestimated. A large part of the reason for this is that risk calculations are based upon current or recent weather patterns, says EDHEC. These calculations do not take into account what’s coming. That is because it is very difficult to develop a reliable forecasting model because the climate keeps changing in unforeseen ways. For example, extreme weather events that were only supposed to happen once every 100 years are occurring with increasing frequency, says EDHEC.

Source: The IPCC (Intergovernmental Panel on Climate Change)

Floods and storms are the most common types of climate-related events, accounting for 44% and 28% of all climate events from 2000 to 2019 respectively, according to the UN Office for Disaster Risk Reduction (UNDRR). UNRDR has reported that the number of major flood events has more than doubled, while the incidence of storms grew by 40%, during the 2000 to 2019 period which it examined. Also, Fathom’s scientists suggest that flood losses could rise by as much as 26% by 2030. And data from the Swiss Re Institute on the key drivers of economic losses found that floods and tropical cyclones were the two largest drivers of economic losses globally in 2023.

There is a growing realisation by banks that the underestimation of climate risk, and the mispricing of it, could well leave them facing loan losses and impaired balance sheets.

That is largely why a group of institutional investors wrote to the Bank of England earlier this year. These investors wanted to warn the Bank of England that UK banks under its supervision may be holding too little capital to withstand the impact of climate change on their businesses due to inadequate disclosures of risk.

The investors want the Bank of England, which regulates how much capital lenders like HSBC, Lloyds, Barclays and NatWest must hold, to require the banks to disclose more and better information about the impact of climate change. (Banks are required to make disclosures under the Pillar 3 section of global bank capital standards from the International Basel Committee).

Meanwhile the European Central Bank’s (ECB) analysis of 112 banks that it supervises, from 2021, reported that none of them were close to meeting its expectations on climate and environmental risks. It did say that these banks had taken initial steps towards incorporating climate-related risks, but none was anywhere near to meeting all supervisory expectations. However, the European Banking Authority does now require banks to carry out scenario analyses on how climate risks might affect their loan portfolios.

Bain suggests that banks need to develop a combination of what it calls defensive and offensive tactics to deal with climate change. On the defensive side it says that banks should impose loan-to-value caps; shift the mix of customer segments; reduce the cost of risk through credit protection insurance; and adjust prices on highly exposed areas to the climate crisis. And on the offensive side it proposes raising discount levels on low-risk assets; pushing for credit protection insurance; and standalone climate risk protection insurance as well.

Bain also makes the point that banks can create a competitive advantage by developing new financing products and advising clients to help them make the transition. Other leading advisory firms also point out that climate change should be seen an opportunity for banks, as well as being a danger for them.

Massive amounts of capital and new financial products will be required to fund the transition to a lower-carbon economy; banks will have a central part to play in all of that. Those that are first to grasp the opportunity could find that their businesses are transformed because of what is coming to the global economy as a result of climate change.

The need for high-quality climate data and reliable risk assessment tools

A consensus has emerged right across the finance industry, including at banks, that more progress needs to be made to develop reliable datasets and analytical tools to measure climate risk – both for physical and transition risk. No one would claim that enough has been done to date. Meanwhile the climate crisis problem keeps growing.

It is going to be critical to find a way to properly integrate climate risk into banks’ overall financial risk management frameworks. And for that to happen the widest variety of reliable data is going to be needed in order to accurately evaluate the impact of climate on the value of clients’ assets. Banks often use scorecards to assess the climate risk. The reliability of that scoring is of course entirely dependent upon the quality of the data that they are using.

Therefore, for banks to understand their coming climate-related risks and opportunities, the quality of the data is absolutely key. But there is no standard dataset to date – nor is there yet even a standard methodology or generally accepted approach to doing this either.

As a result, it would be unwise for banks to rely upon a single methodology or dataset. There will likely be developments and changes to them in the next few years. Banks need to ensure that they are using the widest set of data to maximise the chances of coming to the right conclusion.

It is worth emphasising a point that EDHEC made in its research study:  the climate keeps changing and, quite possibly, that change is speeding up.  According to a report by the Intergovernmental Panel on Climate Change, from 2021, an unprecedented climatic change is underway, as the atmosphere, oceans and landmasses are heating up. The rate of sea level rise and permafrost thawing has increased, and there are more and more extreme weather events, with increasingly serious consequences.

Climate VaR: A flawed but viable option for quantifying climate risk

This further underlines the need for extensive, high-grade data. As the academic journal, the Financial and Economic Review, says: ‘Capturing climate risk exposure considerations requires high-quality, systematic and available input data, structured and processed by various models. According to the Basel recommendations, climate risk as a risk factor can be categorised as a traditional risk, so its impact can be translated into credit risk, market risk and liquidity risk, but climate risk exposures can also be analysed and assessed outside these categories, in its own right’.

Analysing and assessing climate risk in ‘its own right,’ as the Financial and Economic Review puts it, requires a commonly accepted framework by banks.  Climate VaR (Value at Risk) is the nearest thing to it, but it is not perfect. The lack of historical data is a particular problem.

Climate VaR applies the concept of traditional VaR to climate-related risks. It helps quantify the financial risks of extreme weather events such as rising sea levels, shifts in temperature patterns, flooding and fires. It provides a quantitative estimate of the amount that could be lost within a given confidence level over a specific time period due to climate-related factors.

Climate VaR’s accuracy depends on the quality and reliability of climate data, risk modelling techniques, and assumptions made regarding the future impacts of climate change. These can vary considerably.

Traditional VaR models rely on reliable historical data to estimate future risk. However, when it comes to climate-related risks, historical data often does not adequately capture the potential magnitude and frequency of extreme weather events or other climate impacts. Also, the data can take a long time to collect, and it can get out of date very quickly. Nonetheless Climate VaR looks like being the least bad alternative for measuring climate risk. It is dependent upon the quality of the data that is put into the model but that will improve.

In theory, climate risk should not be treated differently from any other form of financial risk. This principle is established in the TCFD (Task Force on Climate-related Financial Disclosures). And progressively climate risk will likely become just another part of risk management at banks. But many acknowledge that this will take some time. The banking industry, along with everyone else, is still learning how to calculate climate risks.

In the meantime climate-related perils are on the rise. They threaten banks’ loan portfolios however they also offer new business opportunities too. Banks that are quickest to grasp the opportunities will likely be playing a key role in the businesses of the future.

We are still at the early stages of what might be a long transition to finding a reliable and dependable way of measuring and calculating climate change risk.