What? Where? When? Reflection of climate risks in financial stability reports

The topic of climate is becoming increasingly prominent in society, as people grow more aware of climate change and feel it firsthand. Google Trend data (Chart 1) show the following trends:

• The relevance of the climate topic grew rapidly in 2018, followed by a period of volatility.
• Interest in climate change has remained relatively stable, with the exceptions in 2022, 2023, and the second quarter of 2024 (April). The increased attention during these periods may be related to the publication of significant climate reports. In April 2022, the Intergovernmental Panel on Climate Change (IPCC) finished the Sixth Assessment Report on Mitigation of Climate Change, but in April 2024, the World Meteorological Organisation (WMO) published the European State of the Climate 2023 Report. The heightened interest may also be attributed to extreme heat experienced in Southwestern Europe in April 2023 or the global temperature record set in April 2024. Naturally, other factors could have contributed as well.
• The topic of climate justice experienced a brief surge in popularity at the end of 2009, followed by a gradual increase in relevance since 2018. December 2009 is notable for the United Nations Climate Summit (COP15) held in Copenhagen, which was accompanied by widespread protests from environmental activists. The main reason for the protests – the injustice towards developing countries, which have contributed relatively little to climate change but suffer and will continue to suffer the most from its effects.
• Society's interest in climate risks has increased more substantially since 2021. Interest in climate risks was stable until 2017, but then started increasing.

Financial stability reports of central banks and the European Insurance and Occupational Pensions Authority (EIOPA)[1] show similar trends (Chart 2). The first observations related to the negative impact of climate change on the insurance sector were already published in 2007. However, initially this topic was addressed only by a few central banks and did not involve extensive analysis. In 2019, the European Central Bank (ECB) acknowledged that climate change can influence not only the insurance sector but also other financial sector organisations. In 2017¬2019, several other central banks also published more extensive explanation or analysis of climate risks. In 2022, climate risks were mentioned or analysed in all of the selected financial stability reports. In terms of the scope of analysis, the greatest attention to climate risks was given in 2019 and 2021.

Mandate of the central banks

Several central banks clearly state that climate risk analysis falls within their mandate. The Swiss National Bank highlights the assessment of the potential impact of climate risks on financial stability as an important aspect of its mandate. Banque de France, the Central Bank of Norway, and Sveriges Riksbank point out that climate risks constitute a source of financial risks, and it is within the mandate of central banks and supervisory authorities to assess these risks and facilitate the financial system's resilience to them. Nationale Bank van België/Banque Nationale de Belgique attributes climate risks to its macroprudential mandate. It allows obtaining information from financial institutions about the monitoring, assessment, and management of the risks related to climate change.

Climate risks are global in nature, they will have a direct or indirect impact on all segments of the economy. This creates financial stability risks; therefore, commercial banks must include climate risks in their risk assessments and ensure adequate capital levels to maintain the resilience of the financial sector. High uncertainty complicates this process, but progress is gradually being made. The uncertainty is related to the scale of climate change, the degree of compliance with the Paris Agreement targets and the pace of change, as well as technological progress and its ability to slow down the rate of climate change[2].

Climate risks are or could become systemic in the future, as they can affect the financial system simultaneously and through several channels. The impact of these risks may be amplified by the fact that they are currently not fully assessed both due to the aforementioned uncertainty  and the specific characteristics of the analysis.  Structural changes related to climate risks cannot be fully captured by risk analysis models based on historical data. Therefore, central banks extensively use future climate scenarios. Several central banks, including Latvijas Banka, not only participate in the development of the scenarios within the Network for Greening the Financial System (NGFS) but also use them for risk assessment[3].

The main focus of central banks is on identifying and mitigating risks, rather than evaluating climate policies and developing recommendations or facilitating achievement of climate goals – tasks that primarily fall under the responsibility of the government. Deutsche Bundesbank[4] points out that clear and targeted climate policy helps reduce uncertainty for the financial system and mitigates risks related to the transition to climate neutrality.

A spectrum of climate risk analyses

Climate risks continue to be a key topic in the majority of central banks. This means that if the topic is addressed in one of the financial stability reports, it is also covered in the subsequent reports (Chart 3). Climate risks are not an annual concern in this type of publication ­in a few countries – namely Estonia, Poland, and Slovakia. This may be due to different research publication strategies, insufficient resources for comprehensive climate risk analysis, data availability issues, and other factors. Climate risks are more extensively reflected in the financial stability reports of the ECB and the central banks of France, the Netherlands, and Slovenia followed by EIOPA and the central banks of Czechia, Malta, Norway, Latvia, Austria, Belgium, Germany, Spain, and other countries.

In most institutions, more than a half of climate-related content is of qualitative nature – primarily focusing on the characterisation of risks and their channels of influence. A relatively higher proportion of quantitative analysis can be found in the financial stability reports of the ECB and the central banks of Poland, Czechia, Latvia, Italy, and Estonia.

Central banks point out that physical climate risks are often systemic, non-diversifiable and their impact is always negative. Credit institutions may incur losses if their clients or the property of their clients have been damaged due to a decline in the value of collateral or for other reasons. Indirect impacts can materialise from trade disruptions, the need to cover adaptation costs, and deteriorating macroeconomic conditions[5]. While some physical climate risks can be assessed to varying degrees, others remain largely uncertain, including the possible scale of climate and nature risks.

Climate transition risks are not systemic, as their impact may vary across sectors making them diversifiable[6]. However, the potential for diversification is limited, as the financial sector's exposure to these risks is largely determined by the structure of the economy. The economy often comprises a relatively high share of industries that are particularly exposed to transition risks (such as those with higher greenhouse gas emissions, greater carbon intensity, lower energy efficiency, inability to pass higher costs onto the prices of their products). Additionally, interlinkages among industries must be considered. Transition risks increase credit risk of financial institutions if their clients face higher transition risks. Other significant risks include reputational risk arising from investment strategies, market risks due to asset revaluations, and litigation risks if investors are not informed about the transition risks of a particular institution.

Quantitative analysis primarily assesses exposures to climate risks. Exposures to physical risks are often assessed as low. Exposures to transition risks depend on the structure of the economy of a particular country. Relatively less attention is given to stress tests and their results. Other types of analysis include quantitative research not covered by previously mentioned categories. Examples include survey results from commercial banks or the population, analysis of green securities, analysis of climate scenarios, and evaluation of risk levels. Latvijas Banka has also analysed exposures to climate risks and conducted stress tests, along with other types of research[7].

Climate transition risks have been studied comparatively more extensively. Although Czechia published its first natural disaster stress tests in 2007, other countries did not follow suit and, since 2017, have focused more heavily on transition risks (Chart 4). Greece is the only country that has not included a quantitative analysis of the transition risks in its financial stability report.

No analysis of physical risks is included in the financial stability reports of eight central banks. Österreichische Nationalbank points out that the focus on transition risks stems from data availability issues rather than the greater relevance of these risks compared to physical climate risks. Other central banks also highlight the lack of adequate data as an obstacle to comprehensive risk analysis. Additionally, analyses increasingly address ESG (environmental, social, governance) risks and lately also biodiversity and other nature-related financial risks.

Additional insights from central banks

Climate risks can materialise and affect financial stability both in the short, medium, and long term. Short-term effects are mainly related to physical climate risks, while medium and long-term impacts – to transition risks. Several examples also highlight the relevance of transition risks in the short term, when politicians make sudden decisions, which are implemented without any delay. For example, after the Fukushima nuclear disaster in 2011, Germany decided to shut down the nuclear reactors, which was subsequently completed by 2025. In the 1960s, all coal mines in the Netherlands were closed within 10 years of the government's decision. Where the enforcement of decisions is foreseeable, it is possible to minimise  transition risks, inter alia, those in the financial sector. It is valuable to conduct short-term analysis alongside the longer-term analysis to take into consideration both short-term fluctuations and longer-term trends thereby achieving a more accurate risk assessment. Difficulties usually arise in evaluating the second-round effects and macro-financial linkages.

Insurance against physical climate risks is important to reduce potential losses; however, due to climate change, insurers may increase premiums or reduce risk coverage to maintain their resilience. Physical risk assessments often note that clients of commercial banks insure properties used as collateral, thereby reducing risk exposure for banks. To date, insurers have successfully dealt with the losses caused by natural disasters, and re-insurers have been able to diversify their risks at the regional level. So far, re-insurance and insurance premiums have increased following major natural disasters. As such events become more frequent, we can expect a more rapid rise in insurance costs or loss of motivation among insurers to provide their products in regions more prone to disasters. This is why insurance schemes are under consideration at both the national and international levels.

The faster the transition to climate neutrality, the lower the long-term physical risks. Consequently, the overall (long-term) costs would be lower than in a scenario without climate action. This includes lower impact on inflation, supply chains, and inefficient allocation of resources. The financial sector can facilitate this transition by leading through example – such as choosing their investment targets, improving the energy efficiency of their buildings, and implementing other measures – as well as by financing relevant projects and companies. Therefore, central banks and supervisory authorities also monitor climate risk management in commercial banks.

Russia's war in Ukraine is mentioned in the context of the urgency surrounding climate transition risks. It illustrates the potential consequences of the situation where the consumption of fossil fuels has to be rapidly reduced. This has facilitated the use of renewable energy resources and improvements in energy efficiency. On the other hand, some countries have opted to expand the short-term use of domestic fossil energy resources. This may necessitate stricter climate policy decisions in the future. There are also concerns that the climate transition could be hampered by increased military spending, which is often linked to higher consumption of fossil fuels, and by the physical consequences of war, such as elevated emissions from fires, damaged infrastructure, and the destruction of forests.

The transition to climate neutrality can provide competitive advantages for certain enterprises. The transition process is related to the development of new technologies. Therefore, some enterprises will be closed or reconstructed, which may increase credit risk or losses for financial institutions. Other enterprises will become more competitive and their credit risk will decrease.

Returning to the resilience of the financial sector, a common conclusion in central bank publications on macroprudential policy is that macroprudential measures will be necessary and useful in mitigating climate risks. Macroprudential authorities may apply instruments that facilitate resilience and, where possible, also limit the build-up of risks. The most frequently mentioned tools in these reports are the systemic risk buffer and borrower-based measures[8].

[1] This research uses financial stability reports of the ECB, EIOPA and the central banks of Austria (AT), Belgium (BE), Croatia (HR), Czechia (CZ), Denmark (DK), Estonia (EE), France (FR), Germany (DE), Greece (GR), Ireland (IE), Italy (IT), Latvia (LV), Lithuania (LT), Malta (MT), the Netherlands (NL), Norway (NO), Poland (PL), Portugal (PT), Rumania (RO), Slovakia (SK), Slovenia (SI), Spain (ES), Sweden (SE), Switzerland (CH) and the United Kingdom (UK) published in English. Other climate-related research publications of the selected institutions were not analysed.

[2] See, for example, financial stability reports of the Bank of England (July 2022), Banka Slovenije (2020), Banco de Portugal (June 2019), and De Nederlandsche Bank (June 2018).

[3] See Financial Stability Report 2023 of Latvijas Banka and Natural disaster strikes: how to tame the loss monster?

[4] See the financial stability reports of Deutsche Bundesbank of 2019, 2021, and 2024.

[5] See the interim report of 2021 of the Central Bank of Malta.

[6] See the Financial Stability Report of 2019 of the Central Bank of Norway.

[7] See the financial stability reports of 2024, 2023, 2022, 2021, and 2020 of Latvijas Banka.

[8] These instruments are already being applied to address climate risks in Latvia, Slovakia, and Hungary.