Adaptation Climate

The High Cost of the Physical Risks of Climate Change for Banks

Thunderheads and lightening portend a coming storm.

Banks play an important role in our economy. Do they also play a role in mitigating climate change? 

Financial institutions can play a big role in helping to minimize the worst impacts of climate change. An analysis by Ceres on the risks banks face from climate change shows that banks that fail to prepare for the energy transition face bigger risks than what has previously been disclosed. The cumulative exposure from the syndicated loan portfolios of the largest banks in the U.S. could be over $500 billion. However, the cost of the total balance sheet is far higher, or as the analysis states, “without a deliberate carbon transition, a future where well-prepared banks can thrive along with the rest of society will not be possible.”

Catastrophic natural disasters continue to increase 

The U.S. and the world experience more and more wildfire seasons, catastrophic flooding, droughts, heatwaves, and hurricanes. July 2021 was the hottest month globally ever recorded, according to the National Oceanic and Atmospheric Administration’s National Centers for Environmental Information. As of September 28, there have been 19 named storms in 2021. In 2020, there were 30 named storms. As many as 45,518 wildfires raged across the U.S. as of September 23, burning over 5.8 million acres. Drought conditions persist across western states. The NOAA estimates the approximate cost of damages from weather and climate disasters in the U.S. from 1980 to 2020 to be $1.875 trillion.

Those physical risks pose big threats to a bank’s portfolio. Combined with the potential transition risks, the risks can potentially impact the safety and soundness of banks. “The reality is they—and the sectors they finance—need to be prepared for an increase in physical climate risk that is already baked into our collective future,” the Ceres’ analysis states.

What banks can do

Prioritizing the worst climate hazards is the first thing that banks should do, then they need to understand how climate change will affect them in the future. Other ways that banks can deal with climate change include:

  • Converting economic impacts on physical assets, labor productivity, and agricultural yields into financial risk metrics. 
  • Accounting for indirect economic impacts on supply chains and national economics. That is a “difficult challenge that no U.S. bank has yet overcome,” the analysis points out.
  • Understand the systemic nature of the growing risks.

Recommendations for banks 

Ceres has a list of recommendations for banks, including assessing all elements of climate risk and opportunity and understanding how the risks affect their businesses and communities. According to McKinsey & Company, the opportunities climate change brings are numerous, including renewable energy, refurbishing plants, and adaptive technologies. Climate opportunities reduce emissions, accelerate the transition away from fossil fuels, and capture and store carbon. 

Another recommendation is for banks to measure the current impact hazards on the value of their financial assets. McKinsey tells of a leading international bank that wanted to increase its share of climate markets. It had to make climate factors a part of a risk management function, plus develop tools for assessing climate risks. The bank’s goal was to assess climate risk for 2,500 counterparties every year. The solution they came up with was to produce scorecards for transition and physical climate risk.

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