## Climate Change and Financial Risk

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**Canonical URL:** [Climate Change and Financial Risk](https://www.imf.org/-/media/files/publications/fandd/article/2019/december/climate-change-central-banks-and-financial-risk-grippa.pdf)

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### Overview
- Climate change affects the financial system through two main channels: physical risks and transition risks.
- The economic impact will likely accelerate and depend on policy choices made today.
- Lower- and middle-income economies are typically more vulnerable to physical risks.

### Channels of Risk (Physical and Transition)
- Physical risks:
  - Arise from extreme weather events and gradual changes in climate.
  - Manifest as asset destruction, credit losses (residential and corporate loans), underwriting losses, lower property and corporate asset value, and reconstruction/replacement costs.
  - Increase in frequency and severity of insurance claims can make insurance more expensive or unavailable in at-risk areas.
- Transition risks:
  - Stem from policy, technology, and changes in consumer preferences as economies adjust to lower carbon emissions.
  - Materialize as market losses (equities, bonds, commodities), lower value of stranded assets, lower corporate profits, higher litigation, and higher funding costs for firms with carbon-intensive business models.
  - Example: fossil fuel companies may face “literally unburnable” reserves (Mark Carney, 2015); US coal mining company share prices reflect a “carbon discount.”

### Financial Sector Impacts
- For banks:
  - Physical risks can increase default risk in loan portfolios and lower asset values (e.g., mortgage portfolios affected by rising sea levels and extreme weather).
  - Tighter financial conditions could follow if banks reduce lending, especially when climate shocks affect many institutions simultaneously.
- For insurers and reinsurers:
  - Both asset-side and liability-side risks increase; underwriting losses and higher claim frequency/severity.
  - Climate change can reduce diversification by increasing correlation across previously uncorrelated events.
- Systemic concerns:
  - Rapid adjustments in asset prices to reflect physical or transition risk can produce financial-stability concerns.
  - Markets may be partially pricing climate risks, but asset prices may not fully reflect potential damage or required policy action to limit global warming to 2 ̊C or less.

### Policy and Regulatory Responses
- Prudential policy adaptation:
  - Prudential policies should adapt to recognize systemic climate risk—for example, by requiring financial institutions to incorporate climate risk scenarios into their stress tests.
  - Caution: allowing financial institutions to hold less capital against debt labeled as green could backfire if underlying risks are not adequately measured, increasing leverage and financial instability.
- Central bank actions:
  - Central banks should revise frameworks for refinancing operations to incorporate climate risk analytics, possibly applying larger haircuts to assets materially exposed to physical or transition risks.
  - Within mandates, monetary policy frameworks may need adaptation because climate change can slow productivity growth and heighten uncertainty and inflation volatility.
  - Central banks can lead by example by integrating sustainability considerations into investment decisions for portfolios under their management (own funds, pension funds, and, to the extent possible, international reserves), following NGFS recommendations.
- Supervisory actions:
  - Incorporate climate change scenarios into stress tests of insurance firms and banks (example: UK prudential regulators).
  - Comprehensive climate stress testing requires much better, standardized data.

### Role of the Financial Sector and Sustainable Finance
- The financial sector complements fiscal measures (e.g., carbon pricing) by mobilizing resources for mitigation and adaptation.
- Global investment requirements:
  - Investments in infrastructure alone require about $6 trillion per year up to 2030 (OECD 2017).
- Size and growth of sustainable finance:
  - Estimated global asset size of sustainable finance ranges from $3 trillion to $31 trillion.
  - Green bonds stock estimated at $590 billion in August 2019, up from $78 billion in 2015.
- Channels for investors:
  - Provide financial protection (insurance, catastrophe bonds).
  - Finance mitigation and adaptation via lending, investment, engagement with management, and investor activism.
- Challenges:
  - Measuring environmental impact of sustainable investments is difficult.
  - Risk of “greenwashing” and insufficient investor confidence if policy action lags.

### The IMF’s Role and Actions
- Integrating climate change risks into IMF macro-financial analysis and advice is critical given the magnitude and global nature of risks.
- Stress-testing and Financial Sector Assessment Program (FSAP):
  - Stress testing is a key component of FSAP; examples include scenario-based stress tests analyzing severe hurricane impact in The Bahamas and massive natural disaster in Jamaica.
  - IMF is conducting an analysis of financial system exposure to transition risk in an oil-producing country.
- Collaboration and data:
  - IMF has joined the NGFS (Network of Central Banks and Supervisors for Greening the Financial System), which currently comprises 48 members, and collaborates on developing analytical frameworks for climate-related risks.
  - Closing data gaps and standardizing climate-risk disclosures in financial statements are crucial; IMF supports adoption of Task Force on Climate-related Financial Disclosures (2017) recommendations.
- Analytical priorities:
  - Further improve stress tests to capture long-horizon climate risks and new methodological approaches.
  - Assess macro-financial transmission of climate risks and ensure prudential frameworks reflect actual risks.

### Key Findings, Recommendations, and Scenarios
- Key findings:
  - Climate change creates both physical and transition risks that can damage financial stability through asset-price adjustments, credit losses, and insurance liabilities.
  - Lower- and middle-income economies are more vulnerable to physical risks.
  - Financial system can be part of the solution by mobilizing capital for mitigation and adaptation.
- Policy recommendations:
  - Require climate risk scenarios in supervisory stress tests.
  - Adapt prudential policies to recognize systemic climate risk while avoiding weakening capital standards for labeled green debt.
  - Revise central bank refinancing frameworks to incorporate climate risk analytics and consider larger haircuts on exposed assets.
  - Integrate sustainability considerations into central bank and public investment portfolios where possible.
  - Support standardized, comprehensive climate-risk disclosures consistent with Task Force on Climate-related Financial Disclosures (2017).
- Scenario examples in practice:
  - FSAP scenario-based stress tests analyzing severe hurricane impacts (The Bahamas) and massive natural disaster (Jamaica).
  - Ongoing IMF analysis of transition risk exposure in an oil-producing country.

*Article by Pierpaolo Grippa, Jochen Schmittmann, and Felix Suntheim; draws on Chapter 6 of the October 2019 Global Financial Stability Report.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2019/december/climate-change-central-banks-and-financial-risk-grippa.pdf_