Climate Change and Financial Risk

Climate Change and Financial Risk

Central banks and financial regulators are starting to factor in climate change

"For financial institutions, physical risks can materialize directly, through their exposures to corporations, households, and countries that experience climate shocks, or indirectly, through the effects of climate change on the wider economy and feedback effects within the financial system.

Exposures manifest themselves through increased default risk of loan portfolios or lower values of assets. For example, rising sea levels and a higher incidence of extreme weather events can cause losses for homeowners and diminish property values, leading to greater risks in mortgage portfolios. Corporate credit portfolios are also at risk, as highlighted by the bankruptcy of California’s largest utility, Pacific Gas and Electric. ... Tighter financial conditions might follow if banks reduce lending, in particular when climate shocks affect many institutions simultaneously."

For insurers and reinsurers, physical risks are important on the asset side, but risks also arise from the liability side as insurance policies generate claims with a higher frequency and severity than originally expected. There is evidence that losses from natural disasters are already increasing. As a result, insurance is likely to become more expensive or even unavailable in at-risk areas of the world. Climate change can make banks, insurers, and reinsurers less diversified, because it can increase the likelihood or impact of events previously considered uncorrelated, such as droughts and floods."

Transition risks materialize on the asset side of financial institutions, which could incur losses on exposure to firms with business models not built around the economics of low carbon emissions."

Extracted from IMF Newsletter