Climate change risks and its impact on financial system

RBI issued Keynote on Climate Change Risks on 13th Mar 2025

There are essentially two types of risks emanating from climate change that we need to address: physical, and transition risks.

Physical risks stem from both gradual and sudden climate impacts, such as natural disasters, affecting real assets and financial instruments. These risks cause direct damage to assets, leading to loan losses and collateral damage, as well as indirect costs, including business disruptions, capital replacement, and supply chain issues. These risks can affect trade, fiscal policy, monetary policy, and financial stability, requiring ongoing assessment. Estimating loan losses from physical risks is difficult due to lack of historical data on such losses, as financial institutions have not tracked them. Even the available data is of limited use due to the changing frequency, intensity, and location of physical events making projections based on past data a bit risky. Such data on loan losses is important for financial institutions as they impact credit risk, including the probability of default and loss given default.

Transition risks arise from efforts to mitigate climate change. It arises from the need for transition by the firms and economies as they strive to achieve their net zero targets, which can be disruptive. It could be a result of adaptation to low carbon technologies, as well as change in consumer behaviour, investor preferences about investments to specific sectors. It can also be a fall out of climate related regulations such as carbon pricing and taxes, transparency requirements, products, and service regulations. Thus, the transition risk emerges because of a disconnect arising from the expectations of various economic factors and could lead to rapid economic adjustment costs in a broad range of sectors. It creates uncertainty for firms and investors, which may further lead to financial risks, with its resultant impact on financial stability.

Climate related risks may also lead to macroeconomic impact on households, companies, and sovereigns affecting consumption, production, and investment patterns. Given their exposures to firms whether in the form of credit or investments, as well as their own operations, these risks impact the financial institutions through traditional risks categories of credit, market, liquidity, and operational risks. These losses may get amplified through interconnectedness among the financial sector players, between the financial and non-financial sectors, as well as within the non-financial sector. The inter-linkages between physical risk and transition risk may also act as a particular source for non-linear risk impacting financial stability. These risks may also get magnified through cross border trade and production interdependencies

Dimensions of Climate Change Risks

There are two dimensions to climate change related risks that we as regulators, policymakers and practitioners have to be aware of

– the first is facilitative involving capacity building, development of the ecosystem and financing of green and sustainable transition; and

– the second is the prudential aspect, which is related to risk management.

Role of Central Bank:

• Role of the Central Banks in managing risks posed by climate change to the financial system is increasingly being recognised,
• their role in facilitating the financing of green and sustainable transition has been a matter of debate and has varying dimensions to it.
• Central Banks in Advanced Economies have traditionally followed an asset neutral approach.
• Central Banks in Emerging Markets and Developing Economies (EMDEs), on the other hand, have adopted directed lending policies to channelise credit to certain sectors of their economies given their individual country circumstances and developmental objectives.

Types of financial risks:

• Major types of financial risks – be it credit, market, or operational risk
• These risks include losses from credit portfolio due to extreme climate events or natural disasters (physical risks) and loss in value of collaterals due to stranded assets (transition risks); losses from investments; and operational losses.
• Although climate change impacts almost all economic sectors, the extent and nature of these risks vary by sector, industry, geography, and institution.
• The mitigation of climate change risks, therefore, rests – firstly, on realistic and comprehensive assessment of the frequency and severity of climate risks and secondly, estimating their financial impact, which is no easy task.

Evolution of climate change risks and mitigation for the Indian Financial System by RBI

• Over the short-term, our goal is to be able to make a realistic estimation of the impact of climate related risks not just on individual institutions but also on the financial system as a whole. This would involve scenario analysis and stress testing exercises, using both bottom-up and top-down approaches.
• Several jurisdictions have started work on the assessment and disclosure of climate related risks.
• International organisations such as International Sustainability Standards Board (ISSB) of the International Financial Reporting Standards (IFRS) Foundation has released standards on climate related disclosures.
• The Basel Committee on Banking Supervision (BCBS) has also released a consultative document on disclosure of climate-related financial risks with a view to integrate climate risk related disclosures under the Pillar III disclosure requirements of the Basel framework.
• The impact of climate change risks is not limited to the financial system alone but extends to the real economy. Be it the corporates or the MSMEs or the agricultural sector, climate change risks are ubiquitous.

Maxine Nelson, Ph.D, Senior Vice President, GARP Risk Institute, currently focusses on sustainability and climate risk management. She has extensive experience in risk, capital and regulation gained from a wide variety of roles across firms including Head of Wholesale Credit Analytics at HSBC. She also worked at the U.K. Financial Services Authority, where she was responsible for counterparty credit risk during the last financial crisis.