Why is Climate Change Important for Financial Institutions?

The term “climate change”, or more recently just “climate”, is shorthand for a wide gamut of topics that span the physical impacts of changing weather behaviour, the net zero energy transition, and the evolving legal and regulatory environment that is designed to price climate into global markets.

Given this broad scope, climate can impact financial institutions (FIs) in a myriad of ways. The pathways to risks (and opportunities) are diverse, and require a range of tools and expertise to properly assess them.

FIs have been undertaking sustainability reporting for several decades[1]. More recently, there has been a focus on climate as a separate topic worthy of it’s own reporting line[2]. With the release of global sustainability reporting standards specific to climate[3], and the alignment of multiple jurisdictional legislation on mandatory climate reporting with these standards[4], there is an increasing focus on climate reporting as a distinct financial risk separate to the broader ESG agenda.

A review of some of the major banks’ climate reporting suggests there are four broad areas that financial institutions are focussing on when it comes to physical climate risk:

• Credit risk
• Liquidity risk
• Operational risk
• Capital stress

But it’s not just about the climate. Over the multi-year periods that banks hold a position for, it’s not only the climate that can change the risk environment. Our present day understanding of natural hazard risk is uncertain and can move around. Recent extreme events may also skew our heuristic understanding of risk, and appetite for it, due to “recency bias”[5]. Even the actuarial approach to risk is inherently uncertain[6]. Inputting the same data into different catastrophe models will likely render different numbers. Sometimes, this spread of views can eclipse the future climate change signal.

So, what can be done? The first step to understanding climate risk is quantification. FIs need to know where climate risk lies on their books before they can do anything about it. Given the importance of insurance in terms of absorbing financial costs and as a cost to consumers that could impact affordability, it makes sense that FIs should leverage tools and datasets that insurers themselves use for pricing climate risk. Once climate risks are quantified, the conversation around what to do about them can begin.

FIs have a lot to gain in leveraging the tools currently used by insurers to price climate risk, and work collaboratively with them to build a more resilient and sustainable property market for all.

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[1]Baldissera, Corporate Social Responsibility and Environmental Management, Wiley Online Library, Sustainability reporting in banks: History of studies and a conceptual framework for thinking about the future by learning from the past, April 2023

[2] For example, 2023 Climate Report (nab.com.au), 2023 Climate Report – CommBank, and Westpac-2023-Climate-Report.pdf

[3] IFRS, IFRS S2 Climate-related Disclosures, 2023

[4] Examples across the Asia Pacific region include Australia Climate-related financial disclosure – consultation paper (treasury.gov.au), New Zealand Appendix 1. Climate and sustainability reporting progress | Ministry of Business, Innovation & Employment (mbie.govt.nz), Singapore Singapore to implements ISSB Standards from 2025 | XBRL, Hong Kong Hong Kong Exchange to Require IFRS-based Climate Disclosure Beginning 2025 – ESG Today and Malaysia Malaysia consults on adoption of ISSB standards (iasplus.com)

[5] Kahneman, Thinking, Fast and Slow, July 2012

[6] Aon, Climate Risk: Reconciling Experience and Statistics, August 2023