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Report

Addressing challenges of physical climate risk analysis in financial institutions

Started in 2017, the ClimINVEST project gathered European climate experts to work together with financial institutions to better understand the challenges of physical climate risk management in finance and develop information and resources.

ClimINVEST identified four main categories of challenges that were partly addressed in the project.

Key points

Challenge 1. The black box of climate services: it is now partly opened

Service providers have developed proprietary and heterogeneous methodologies to help financial actors analyze their exposure to physical climate risks. As standards on physical climate risk analysis do not exist yet, the limited explanation on these methodologies and underlying data sources has reduced the capacity of financial actors to understand them and potentially use them for decision-making. The ClimINVEST project raised attention of service providers on this issue and helped improve the transparency on key methodological choices, with constraints due to proprietary model confidentiality. This reveals a patchwork in available services that financial users can navigate by gaining capacity to ask the right questions to service providers.

Challenge 2. The tragedy of the horizon: it is not a justification for inaction now at financial institutions
Climate change is a threat to financial stability, partly due to misalignments between short-term decision-making in the financial sector and the expectation that climate impacts are essentially a problem in the distant future. Financial actors may view this ‘tragedy of the horizon’ as a reason for inaction now. Nevertheless, as financial actors gain more insight into climate risk issues, they understand that physical impacts are already being realized with damage costs. Some financial institutions are also interested in long-term climate conditions, such knowledge allowing them to seize business opportunities with their clients and for broader strategic developments.

Challenge 3. The data: financial actors can already act on existing data
Physical climate risk analysis requires relevant and specific climate data and asset-level or portfolio-level data and information. While most climate data is openly available, navigating the multitude of data sources and types of data can be challenging and may require complex processing systems. Further, asset-specific data is needed for every individual case and often confidential, which makes it difficult to collect for large portfolios. The ClimINVEST factsheets and interactive online platform offer guidance to identify the relevant data needed for physical climate risk assessments in different sectors and illustrate the relevant use cases of a range of climate indicators and counterparty-level data.

Challenge 4. Estimating financial impacts: it is not vital for managing climate risks
Financial actors have pointed the need to make progress on the quantification of financial consequences from climate risks. General estimates of climate change losses in a sector or region have been previously conducted. However, calculating the cost of climate impacts on individual assets or portfolios proves challenging due to data constraints, asset connectivity and uncertainties in risk modelling. The banking institutions participating in the ClimINVEST project concluded that while estimation of financial impacts was helpful for integration in main financial risk models and metrics, it is not vital for managing risks quickly. Considerations about the financial consequences from potential climate impacts can be drawn from qualitative information as well, as it is done in some cases with climate risk scoring methodologies. The banks can leverage such scores in their risk decision-making provided that the underlying methodology is transparent and that relevant detail is provided about the type and materiality of potential impacts.