Outdated climate impact assessments in finance

The report "Recalibrating Climate Risk: Aligning Damage Functions with Scientific Understanding" argues that current economic models significantly underestimate the unknown of future climate impacts. The document focuses on the profound uncertainty inherent in "damage functions"—the mathematical tools used to predict how global warming will affect GDP—and highlights a dangerous disconnect between economic theory and scientific reality. The report emphasizes that the future will be defined by "extremes," not the "averages" currently used in most models. There is significant uncertainty regarding the frequency and intensity of "tail risks"—low-probability but catastrophic events like massive storms or heatwaves. Unlike steady economic growth, climate damage is expected to be "non-linear," meaning small increases in temperature could lead to sudden, disproportionate economic collapses that current models fail to predict. A major wildcard is the potential for "planetary tipping points" (e.g., the melting of permafrost), which introduce "bounded collapse probabilities" that are currently omitted from standard risk assessments. Future uncertainty is exacerbated by how damages interact across different sectors and geographies. Damages are described as "cascading and long-lasting," where a failure in one sector (like agriculture) can trigger unpredictable "capital destruction" and "labour productivity losses" across the entire economy. There is deep uncertainty about how damage "compounds across time, space, and sectors," making it difficult for financial regulators to assess the true level of systemic risk. The report identifies "direct and indirect" failures in how climate risk is currently quantified. Much of the current future uncertainty stems from "arbitrary" functional forms and hidden assumptions in Integrated Assessment Models. While incorporating "expert knowledge" can help, the report notes that these judgments may be "biased" and that there is a lack of "expert confidence" when dealing with higher temperature levels. There is a "fundamental disconnect" between climate science and the "top-down macroeconomic perspective" used by financial regulators and investors, creating a "blind spot" for future climate-driven financial crises. The report suggests that the "greatest unknown" is the point at which climate damage exceeds the system's ability to adapt. To navigate this, researchers and regulators must move beyond "aggregate functions" and embrace "process-based approaches" that explicitly quantify the massive uncertainties of a warming world.

𝗝𝘂𝘀𝘁 𝗥𝗲𝗹𝗲𝗮𝘀𝗲𝗱: 𝗨𝗡𝗘𝗣 𝗙𝗜 & 𝗚𝗹𝗼𝗯𝗮𝗹 𝗖𝗿𝗲𝗱𝗶𝘁 𝗗𝗮𝘁𝗮 𝗦𝘂𝗿𝘃𝗲𝘆 𝘀𝗵𝗼𝘄𝘀 𝗰𝗹𝗶𝗺𝗮𝘁𝗲 𝗿𝗶𝘀𝗸 𝗶𝘀 𝗰𝗿𝗲𝗱𝗶𝘁 𝗿𝗶𝘀𝗸. 𝗕𝗮𝗻𝗸𝘀 𝗮𝗿𝗲 𝘀𝘁𝗶𝗹𝗹 𝗻𝗼𝘁 𝗱𝗼𝗶𝗻𝗴 𝗲𝗻𝗼𝘂𝗴𝗵. Regulators have raised the bar for climate disclosure, but banks are still a long way from embedding climate risks into their business. 🔸  Collateral value adjustment remains low. Just 12% of banks adjust collateral for physical risk, and only 4% for transition risk. 🔸  ESG integration is fragmented. Over half of banks have internal ESG scoring, but there's no consensus. Few banks tie ESG directly into credit decisions, methods vary and full integration into ratings is rare. 🔸  Scenario analysis is widespread, but validation is not. 85% of banks use NGFS climate scenarios, but fewer than 5% regularly backtest climate impacts in credit models. 🔸  Incorporating climate into key credit metrics is lagging. Metrics like Probability of Default (PD), Loss Given Default (LGD) and Internal ratings-based (IRB) models remain inconsistently or only partially integrated with climate risk considerations. 🔸  Adjustments to ECL (Expected Credit Loss), RWA (Risk-Weighted Assets) and Economic Capital remain low and still in early, exploratory stages. Most banks report financial impact for climate risks between 0-2.5%. For transition risks, this increases to 5-10% but this is not reflected in key metrics. There remains a significant gap in quantification and adoption for capital impact. 🔸 Many banks still rely on expert judgement over data-driven models. While climate risk is assessed across major portfolios, most banks depend on judgement, due to data and methodological constraints. 🔸 Data quality & granularity are key obstacles. Obstacles to robust, forward-looking climate data (especially Scope 3) push banks toward proxies and general averages. 𝗠𝘆 𝗧𝗮𝗸𝗲 The UNEP report shows the banking sector still struggles to consistently quantify and integrate climate risk in credit portfolios, capital models, and client processes. Most banks remain reliant on expert judgment and qualitative overlays, mainly due to the lack of granular, forward-looking data and practical scenario analytics. Scenario analysis exists but is rarely deeply embedded in major decisions, and backtesting is the exception. This is where data-driven platforms are critical. Delivering granular scenario analysis, data harmonisation, and dynamic simulation enables banks to move beyond overlays to defensible, auditable climate risk insights. The leaders will be the banks who industrialise scenario analytics and make regulatory pressure a driver of real competitive advantage. #ClimateRisk #CreditRisk #Banking #ESG #RiskManagement #SustainableFinance Source: https://lnkd.in/eC4S8mRN ___________ 𝘛𝘩𝘦𝘴𝘦 𝘷𝘪𝘦𝘸𝘴 𝘢𝘳𝘦 𝘮𝘺 𝘰𝘸𝘯. 𝘍𝘰𝘭𝘭𝘰𝘸 𝘮𝘦 𝘰𝘯 𝘓𝘪𝘯𝘬𝘦𝘥𝘐𝘯: Scott Kelly

Happy to share a recent working paper, "Impact of Climate Scenario Choices on Climate Financial Risk Assessment," with colleagues at the Oxford Sustainable Finance Group, UK Centre for Greening Finance and Investment (CGFI), and Theia Finance Labs. Key takeaways: 1.    Widespread heterogeneity in climate scenario providers and trajectories indicate large uncertainty for financial institutions in assessing corporate climate transition scenario pathways. 2.    This has significant implications for climate financial stress testing that are premised on climate scenario pathways to meet certain temperature targets and policy ambitions. 3.    A consistent, bottom–up, climate financial stress test is applied to 3,419 power companies using different scenario trajectories and provides two main impacts: net present value (NPV) and probability of default (PD). 4.    Five scenarios are compared under a goal of reaching a global average surface temperature increase of below 2°C, and four scenarios are compared under a goal of reaching global Net Zero by 2050. 5.    Distribution of NPV changes under the stress test show that there are significant differences based on the climate scenario. This can impact the assessment of market and credit risk for companies. 6.    Analysis of individual power technologies indicate that the heterogeneity in company performance is technology specific and likely driven by assumptions in Integrated Assessment Models. 7.    Renewable power companies show improvement in NPV under any stress scenario, but there is some disagreement on the extent to which coal, gas, and oil companies show reduction in NPV. 8.    Hydro and nuclear technology power companies show the greatest uncertainty in financial performance (i.e., NPV) depending on the climate scenario being used. 9.    Results of probability of default (PD) change show similarly conflicting results with high variation in a company’s PD, however we observe higher levels of agreement between scenarios compared to NPV change. 10. Further research is needed to address both the uncertainty and assumptions in climate scenario trajectories as they are applied to financial climate risk analysis. #climaterisk #transitionrisk #stresstests #scenarioanalysis #integratedassessmentmodel #powergeneration #netpresentvalue #probabilityofdefault https://lnkd.in/gV2swsNr

🌍 A Wake-Up Call for Financial Institutions: Physical Risk at the Asset Level New research in Nature reveals that current assessments of climate physical risk are drastically underestimating potential losses by up to 70% when neglecting asset-level information. Acute climate events, like hurricanes, also amplify these risks, potentially leading to underestimations of up to 82%. For financial institutions, this means that traditional risk models could be dangerously inaccurate. Integrating granular, asset-level data is crucial for accurate risk management and investment strategies. This report provides a powerful five-step framework for doing so🌱📊 👉https://lnkd.in/en97BTtj #climate #climaterisk #climatefinance #climatedata #esgdata #sustainability #risk #finance #assets #riskmanagement #climateimpacts #climatescience

Incredibly important report alert. The Financial Stability Board (FSB) have produced a new Assessment of Climate-related vulnerabilities, including an analytical framework and toolkit for its members. The analysis makes for sobering reading but it is also a really important development to see these risks and the way in which they could manifest within and be amplified by the financial system recognised by the FSB. What will be critical is how this analysis feeds through into the response of members and, in turn, the way that these risks and monitored, managed, and mitigated within the financial system. The impacts the Assessment considers are ones that need to be avoided pre-emptively through actions taken now whilst that remains possible, rather than seeking to deal with the consequences after the event, which makes this Assessment an important and welcome step. A couple of key excerpts: - "Climate-related vulnerabilities in the financial system, when triggered by climate shocks, could threaten financial stability through various transmission channels and amplification mechanisms.  This can be more complicated than for non-climate shocks given uncertainties around their timing and magnitude, non-linearities from tipping points, as well as second-order and spillover effects." - "The interactions of transition and physical risks or among physical risks could be a particular source for non-linear climate dynamics and compound climate shocks could be further amplified by existing financial vulnerabilities, such as asset mispricing or high leverage, creating financial losses." - "Once crystallised, climate-related risks are transmitted and amplified through the traditional channels used in financial stability assessments, including credit, market, and liquidity risks. Climate shocks could also affect the real economy through damage to real assets or the creation of stranded assets, or a disruption to economic activity that can feed back to the financial system. Risks that are opaque and not well-managed could create correlated shocks whose impact is magnified as they propagate through the system." - There is a specific case study that looks at physical risk impacts on real estate markets and envisages a series of extreme climate events that results in direct damages and a reassessment of physical risks, leading to larger uninsured property damages and increased bank credit risk. There are then potential amplification mechanisms including reduced bank lending, and "an abrupt, broad-based repricing of climate-physical risk, as the expectation of larger future losses are incorporated into current prices and impact sectors and jurisdictions not currently directly affected by disasters". With the impacts we have sadly already seen in 2025, including in Los Angeles, this feels particularly prescient. Link to report below and to an FT article on the same in the first comment. https://lnkd.in/ejmS-ZMD