What are the climate related ESG risks for banks?
Climate risks are often categorized into physical risks and transition risks.
Banks can be exposed to the physical risks of climate change when severe weather events like floods, fires, and hurricanes result in borrowers’ damaged assets being devalued. This could lead to increased loan default rates, resulting in increased credit risk. In addition, banks that hold collateral assets of fossil-fuel or other carbon-intensive industries may face transition risks of climate change and stranded asset risks. For example, the introduction of a new climate regulation could reduce the demand of fossil fuels, thus devaluing coal reserves.
Insurance companies may also be negatively affected by both physical and transition risks through their underwriting and investment activities. For instance, the value of their real estate portfolios located in areas facing increased physical risk of climate change could be decreased. The NYDFS issued an Insurance Circular Letter asking NY domestic and foreign insurance companies to integrate climate risks in their risk management and governance frameworks, as well as business strategies.
Practice Tip: Best practices include identifying climate risks across all asset classes, sectors, and geographies of a portfolio. Assets in certain jurisdictions could be more vulnerable to the impact of physical risks of climate change such as droughts and sea-levels rise than others.
Nature-related risks (e.g., biodiversity loss) may expose financial institutions to increased risks such as credit and reputational risks through their operations or services. For example, a company that causes damage to natural resources or biodiversity could be exposed to litigation. As a result, the company’s assets could be tied up, resulting in loss of revenue, production, and eventually slowing or stopping overall operations. This would expose financial institutions to credit risk, as it affects the company’s ability to repay its loans. Additionally, financial institutions that lend to or invest in companies or projects that cause biodiversity loss may suffer reputational damage and risk losing new business opportunities as customers may opt for financial institutions with a better reputation for sustainability.
A group of financial institutions and private firms formed the Taskforce for Nature-related Financial Disclosures to develop guidelines for the financial sector to better understand and disclose how they manage risks related to biodiversity loss.