Climate risk · RiskAtoms Academy

By the end you will be able to

1Tell physical risk (acute and chronic) apart from transition risk.
2Trace how both reach a firm as credit, market, operational, liquidity and insurance risk.
3Explain how climate scenarios trade physical risk against transition risk.
4Name the main supervisory expectations: the BCBS principles and the NGFS scenarios.

Why it matters

A flood can damage a borrower's factory, a bank's branch and thousands of insured homes in one night. A new carbon tax can cut the value of a whole industry in one budget. Climate change reaches a financial firm through every door it has.

Core explanation

Two kinds of climate risk, many channels

Supervisors and the Network for Greening the Financial System (NGFS) split climate-related financial risk into two drivers. Getting the split right matters, because the two call for different data and often pull in opposite directions.

Physical risk

Losses from the climate itself changing.

Acute: more frequent or severe extreme events, such as floods, storms, wildfires and heatwaves. Chronic: slow, lasting shifts, such as higher average temperatures, rising sea levels and changing rainfall.

Transition risk

Losses from the move to a lower-carbon economy.

Changes in policy (carbon prices, bans), technology (cheaper renewables and electric vehicles) and market preferences (customers and investors switching), plus the legal claims that can follow. Some assets become stranded.

Note what transition risk is not: it is not the damage from climate change, but the cost of adjusting to prevent it. A coal mine faces transition risk; a seaside hotel faces physical risk.

Sort itPhysical or transition?

A wildfire destroys homes that secure the bank's mortgages.
Year after year, hotter summers cut crop yields for the bank's farming customers.
The EU tightens emissions limits and the carbon price rises sharply.
Electric cars become cheaper than petrol cars, and second-hand petrol car prices fall.
Rising sea levels make a coastal town's homes hard to insure.

A driver, not a box. As L2.2.01: A map of risk types said, climate is not a new risk type next to market or credit risk. It is a cause that reaches the firm through the existing types, along transmission channels. The Basel Committee describes these channels: a flood hurts a borrower's ability to repay and the value of its collateral (credit); a carbon price re-prices shares and bonds of high emitters (market, L2.2.02: Market risk); a storm closes the firm's own offices (operational, L2.2.05: Operational risk); after a disaster, customers draw down deposits and credit lines (liquidity); and, for insurers, claims rise (insurance).

Tag itTrace each climate driver into Example Group

Switch on every risk type through which each event reaches Example Bank plc or Example Insurance SE.

A severe river flood hits a region where the bank has mortgages and business loans, a branch and a data centre, and where the insurer covers homes.
A sudden rise in the carbon price hits the bank's loans to cement and steel makers, and the insurer's shares in oil companies.
Cheaper electric vehicles cut the resale value of petrol cars that secure the bank's car loans.
A hurricane season causes record claims; the insurer sells bonds quickly to pay them.
Investors suddenly re-price climate risk, and the spreads on bonds of carbon-heavy companies widen across the market.

Scenarios, not history. Past data say little about a climate that has never existed, so firms use scenarios. The NGFS publishes a set that central banks use worldwide. Broadly: an orderly transition (early, gradual policy: moderate transition risk, lower physical risk), a disorderly one (late, sudden policy: high transition risk), and a hot house world (little action: low transition risk, high and rising physical risk). There is no scenario with neither.

Where this goes next

Climate scenarios, climate stress tests, disclosure and supervisory expectations are covered in M6.2: Climate and ESG risk. The channels you traced here are measured with the tools of Level 3: Core Risk Disciplines, and the stress testing rules sit in M4.9: Supervision, stress testing and disclosure.

Try it

A cement maker, a heavy emitter, borrows from Example Bank plc. With no carbon price its debt is 4.0 times EBITDA and its earnings cover interest 5.0 times. At a carbon price of €100 a tonne, with 50% passed on to customers, leverage rises to 5.3 times. Push the price up, then see how much depends on whether customers will pay more.

Try itA carbon price on a cement maker

Carbon price, per tonne of CO₂€100

Share of the cost passed on to customers50%

The company emits 2 million tonnes of CO₂ a year, earns €400m of EBITDA (earnings before interest, tax, depreciation and amortisation), owes €1,600m and pays €80m of interest. Illustrative figures.

Carbon cost€200m

Absorbed by the company€100m

Debt ÷ EBITDA (was 4.0×)5.3×

Interest cover, EBITDA ÷ interest (was 5.0×)3.8×

The borrower is weaker but still serviceable. The bank would track it as a transition-risk watch name.

Worked example

Flood risk in Example Bank plc's mortgage book

Example Bank plc has £180bn of mortgages (L2.2.03: Credit and counterparty risk). A flood risk map shows that 8% of them are on homes at high risk of flooding. The risk team tests a scenario where floods become more frequent there. Figures are illustrative.

Physical risk becomes credit risk

Step 1 of 5

1
Size the exposure
8% × £180bn = £14.4bn of mortgages in high-risk areas.

Regulatory lens

Basel Committee: its Principles for the effective management and supervision of climate-related financial risks (June 2022) set 18 principles, 12 for banks and 6 for supervisors, covering governance, internal controls, capital and liquidity, risk management and scenario analysis.
NGFS: a network of central banks and supervisors launched in December 2017, which publishes the climate scenarios many supervisors use in their exercises.
National supervisors: for example the PRA's supervisory statement SS3/19 (2019) in the UK and the ECB's guide on climate-related and environmental risks (2020) in the euro area.
Disclosure: the TCFD recommendations (2017) and the ISSB's IFRS S2 standard (2023) ask firms to report their climate risks in a consistent way.

Covered in depth in M6.2: Climate and ESG risk.

Sparks

SparkThe tragedy of the horizon

In a 2015 speech at Lloyd's of London, Bank of England Governor Mark Carney argued that the worst effects of climate change would fall beyond the horizons of most business and political decisions, so no one has the incentive to act in time. The speech helped put climate risk on the agenda of financial supervisors.

SparkA utility undone by wildfires

In January 2019 PG&E, California's largest utility, filed for bankruptcy, citing liabilities from wildfires linked to its equipment. It was widely described as one of the first bankruptcies driven by climate change: physical risk turned into legal and credit risk.

Key takeaways

Physical risk: losses from the climate changing, acute (extreme events) or chronic (slow shifts).
Transition risk: losses from moving to a lower-carbon economy, through policy, technology, market preferences and legal claims.
Climate is a driver, not a separate box: it reaches firms as credit, market, operational, liquidity and insurance risk.
Past data are a poor guide, so firms use scenarios; more transition risk now usually means less physical risk later.
Supervisors expect climate risk in governance, risk management and scenario analysis (BCBS 2022, NGFS).

Reaction

Check what stuck

Glossary

Physical risk: Financial losses from the physical effects of climate change: more frequent or severe extreme weather (acute) and gradual shifts such as rising temperatures and sea levels (chronic).
Acute physical risk: Physical risk from extreme events: floods, storms, wildfires, heatwaves.
Chronic physical risk: Physical risk from slow, lasting shifts: higher average temperatures, rising sea levels, changing rainfall.
Transition risk: Financial losses from the move to a lower-carbon economy: changes in policy, technology, and market or consumer preferences, and the legal claims that come with them.
Liability risk: Losses from legal claims by people who suffered from climate change against those they hold responsible. Often grouped with transition risk.
Stranded asset: Assets that lose much of their value early because the transition makes them uneconomic, such as some fossil fuel reserves.
Transmission channel: The route by which a climate driver reaches a firm's finances, for example through a borrower's ability to repay.
Climate scenario: A consistent story of how the climate, policy and the economy might develop, used to test how a firm would fare.

Deep Dives & Origins

Deep Dives

Carney, “Breaking the tragedy of the horizon: climate change and financial stability”, speech at Lloyd's of London, 29 September 2015. Beginner.
BCBS, Climate-related risk drivers and their transmission channels, April 2021. Intermediate.
NGFS, NGFS Climate Scenarios for central banks and supervisors (updated regularly). Advanced.

Origins

BCBS, Principles for the effective management and supervision of climate-related financial risks, June 2022.
BCBS, Climate-related risk drivers and their transmission channels, April 2021.
NGFS, A call for action: Climate change as a source of financial risk, April 2019.
Prudential Regulation Authority, SS3/19 Enhancing banks' and insurers' approaches to managing the financial risks from climate change, April 2019.
ECB, Guide on climate-related and environmental risks, November 2020.
IFRS Foundation (ISSB), IFRS S2 Climate-related Disclosures, June 2023.

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