Climate Risk

Two families of risk are usually separated. Physical risk comes from the climate itself: sudden events such as storms and wildfires, and gradual changes such as sea level rise and heat. Transition risk comes from the response: carbon prices, new rules, changing technology, shifting customer demand and legal action. Some frameworks add liability risk as its own group. Climate risk is rarely a risk type by itself. It acts as a driver that feeds credit, market, operational, insurance and reputation risk. It is long-dated and uncertain, so firms examine it with scenarios, not forecasts. Supervisors expect banks and insurers to include it in governance, risk appetite and stress tests. Credit committees use it to decide which borrowers and regions need tighter limits within the life of a loan.

A bank reviews its mortgage book and finds 18% of properties lie in areas with rising flood hazard, while 9% of its corporate lending is to coal-dependent firms. It records the first as physical risk and the second as transition risk, and asks the credit team to include both in its next stress test.