Climate Risk
Climate risk tests how physical and transition risks transmit into prudential and operational risks, and how firms govern, measure, scenario-test, and disclose them.
Core rules and concepts
- Physical risk is acute (flood, wildfire, hurricane) or chronic (heat, sea-level rise). Transition risk covers policy, technology, market, reputation, and liability.
- Transmission channels include credit, market, liquidity, operational, and reputational risk; operational examples include business interruption, supply-chain failure, property damage, and legal claims.
- Basel's Principles for Climate-Related Financial Risk Management (2022) cover governance, risk appetite, policies and processes, monitoring, scenario analysis, and disclosure.
- TCFD's four pillars are governance, strategy, risk management, and metrics and targets; IFRS S2 requires Scope 1, 2, and 3 greenhouse gas disclosures and climate scenario analysis.
- Scenario analysis should cover short, medium, and long horizons and plausible pathways (orderly, disorderly, hot house); data gaps require proxies and sensitivity testing.
Worked example
An agricultural lender sets a climate stress: a severe drought reduces farm yields, while a carbon tax raises input costs. Physical risk lowers borrower cash flow; transition risk compresses margins. The bank maps exposures by region and commodity, applies sector-level PD uplift, and finds a concentration in one drought-prone region. It sets a climate risk appetite limit on high-risk sector concentration, adjusts collateral assumptions, and reports the gap to the board. Climate risk changes credit and operational losses, not just reputation.
Traps that cost marks
Treating climate as only ESG or reputation; ignoring transition risk; using only long-term horizons; missing supply-chain and legal channels; relying on issuer disclosures without data-quality checks.