Climate-related risks continue to be incompletely understood by the financial sector. Much of this risk arises from the nature-focused impacts of climate change – biodiversity loss, extreme weather and ecosystem disruption – and is emphasised as the global economy approaches a new era of opportunity in transition finance.

While scientific understanding of the short-term effects of climate change continues to evolve, it is crucial that these insights inform decision-making within financial institutions. However, key barriers remain. These include a lack of data, policy limitations, ineffective jurisdictional implementation and underdeveloped governance frameworks within banks.

To explore this further, the July edition of OMFIF’s Sustainable Policy Institute Journal examines the way climate risk is being approached by the financial sector including the relationship between opportunities and challenges posed by the transition, the importance of nature risk and current trends with scenario modelling. It features key insights from public investors, fund managers, multilateral institutions and central banks.

Physical impacts

Climate shocks, stemming from physical and transition risk, could combine with financial vulnerability and lead to immeasurable financial loss, writes Paul Hiebert from the European Central Bank. Impacts, while difficult to model, need to be addressed by macroprudential policy, borrower-based measures and improved transparency as shocks are unlikely to be isolated events. Linda-Eling Lee from MSCI Sustainability Institute explores some of the worst-case physical risks, outlining that points are not just found in economic hubs, they are also along supply routes, production sites, logistics and storage. She argues that there remains opportunity in the transition and that mapping risk through multiple climate scenarios is essential for capitalising on these.

For Udaibir Das, National Council of Applied Economic Research, the most serious constraint on climate finance as it relates to developing countries today is not simply a shortage of capital, but a persistent mismatch between how finance is structured and how climate action is pursued.

Financial institutions have an important role in addressing climate-related risk but face specific challenges in the accuracy of determining climate impacts as regulatory expectations rise. For instance, David Carlin, D. A. Carlin and Company, states that this is an age of recalibration for sustainability regulations and that firms should take the time to prepare for changes. William Attwell at Sustainable Fitch similarly highlights the rising expectations for financial institutions to report climate-related information, also stating that progress has been limited with new developments in physical risk assessments and issues with data transparency.

Bracing for tipping points

Despite these challenges, there are options available to financial institutions to support the transition. Isabela Ribeiro Damaso Maia of Banco Central do Brasil highlights some of these that fall within central bank mandates, including adjusting regulatory frameworks, more comprehensive data collection and stress testing.

One area that has recently received a lot of attention by the Network for Greening the Financial System is the limits of stress testing and scenario analysis in the short term. Determining the financial impacts of climate change continues to also rely on a broader understanding of environmental tipping points. Sharon Asaf and Sebastian Werner at Citi consider the relationship between scientific and financial modelling, emphasising that limitations in scientific models lead to struggles to precisely replicate climate impacts, particularly in the short term. This problem is similarly reflected in financial modelling, restricting the possibility of short-term analysis accuracy.

The importance of understanding nature risk and environmental tipping points also extends beyond scenario modelling. Lydia Marsden from University College London emphasises that policy-makers need to better understand nature risk and that ecosystem tipping points have far-reaching implications across regions and sectors. Reinforcing this, Marcus Pratsch, 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. Therefore, understanding the risks to biodiversity is essential in creating broader nature-positive business models.

Ultimately, the financial sector is responsible for turning away from nature-negative flows towards activities that mitigate climate change and build resilience, argue Sem Housen and Emily Dahl, United Nations Environment Programme. This shift can be achieved through taxonomies and more effective jurisdictional management of sustainable finance policy. Stress testing is one of the actions that can be taken by financial institutions, including central banks.

The true extent of impact that climate change will have on the financial sector continues to remain somewhat unclear. 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.