Central Banks Rethink Lending with Climate Risk

• While central banks are incorporating climate risk management into financial stability frameworks, focusing on forward-looking methodologies and collaborating with climate data providers can enhance the assessment of physical and transition risks on banks and properties.
• Approaches vary by region: Europe with the ECB and BoE are advancing their climate risk assessment capabilities, while North America with the Fed and BoC are more cautious, especially in integrating severe climate scenarios and detailed data into their financial risk models.
• This regional variation emphasises the need for tailored strategies and advanced tools to effectively address climate risks on property portfolios and resilience of the banking sector.

As of March 2024, the escalating severity and frequency of climate change’s physical effects have led to significant financial losses globally, with estimates suggesting a net economic loss ranging from $3.75 trillion to $24.7 trillion by 2060, adjusted to 2020 dollars.

With the property market exposed to risks like sea level rise, flooding, and extreme weather, damages are disrupting global financial markets, affecting mortgage lending, insurance premiums, and reinsurance capacity.

Central banks in the EU, UK, U.S., and Canada are rethinking lending mechanisms and collateral valuation by incorporating climate risk frameworks to ensure financial stability and promote global climate action.

This article examines how central banks, including the European Central Bank (ECB), Bank of England (BoE), the U.S. Federal Reserve (Fed) and The Bank of Canada (BoC), address climate risks in the property market and their impact on banking resilience.

The ECB is actively working closely with and co-chairs organisations such as the Network on Greening the Financial System (NGFS) to provide and improve scenario and good practices guidelines relevant to banks’ understanding and projection of climate risks in stress test exercises and scenario analysis in the EU and globally.

In June 2024, the NGFS published a revised guide on climate-related disclosure for central banks, urging the latter to apply the Task Force on Climate-Related Financial Disclosures’ recommendations for central banks among other aspects.

In the context of climate risk assessment and data management for instance, the NGFS mentioned in this publication that, while backward-looking methodologies using historical data are useful to identify and disclose past climate-related risks, these methods may underestimate future losses due to the intensifying effects of climate change and the transition to a net-zero economy.

Furthermore, forward-looking methodologies combine historical data with future climate and transition projections, providing a more accurate prediction on potential future risks and mitigation plans, and accounting for the expected increase in frequency and severity of climate-related events, with data providers continuously refining their methods.

The latter could include Climate X’s products:

• Spectra assesses the impact of climate change on the P&L by translating physical climate risks into financial loss metrics at both portfolio and asset levels, integrating seamlessly with portfolio management workflows for quick and independent physical risk assessments.
• Adapt allows for the assessment of an asset’s physical climate risk and potential financial losses, offering customisation options for building parameters and identifying suitable adaptation measures to review their financial cost and return on investment (ROI).

These tools can help overcome the constraints of conventional approaches by supplying precise data on individual assets and projections of financial outcomes.

With detailed climate risk data, central banks can have a better understanding of the long-term risks of climate change on properties used as collateral, ensuring housing prices reflect these risks and protecting against borrower default.

This could result in more informed lending policies, potentially involving modifications to interest rates, the stipulations for collateral, and contractual agreements to lessen financial risks associated with climate change. 

The BoE, in its April 2024 quarterly bulletin, supports that measuring climate financial risks necessitates a critical look at the importance of using backward-looking “proxy” metrics, forward-looking metrics, and scenarios analysis metrics.

Precisely, the Bank understands that relying on proxy data can lead to misinformation about the potential impacts on climate risks. This is because they often overlook planned mitigation efforts by issuers against climate-related financial risks, neglect the costs associated with these emission reduction strategies or any further actions in response to future climate policies, and pose difficulties in converting qualitative proxy metrics into actionable information for integration into risk management frameworks.

Thus, recommended TCFD forward-looking metrics like decarbonisation targets and Implied Temperature Rise (ITR) to address the shortcomings of backward-looking metrics, which don’t account for future decarbonisation plans, although they don’t directly measure financial risks.

In addition, scenario analysis, which models the impact of climate scenarios on asset values, is crucial for climate-related financial risks as traditional risk models based on historical data fail to capture their unprecedented nature and uncertainty.

Nevertheless, engaging with data providers is crucial for pinpointing transition risks within the housing sector, which shapes policies impacting property valuations.

Such collaboration is advantageous for the property market, as it can supply cross-industry data to evaluate the effects of climate change on properties, thus supporting more robust financial and investment choices.

The Fed acknowledged that, following their initial Climate pilot scenario analysis – which evaluated the effects of physical climate risks on residential and commercial real estate loans over a one-year period – banks have identified loan portfolios as vulnerable.

However, the participating banks expressed concerns that the chosen scenarios did not account for severe climate risks. They pointed out that both scenarios were orderly scenarios only, excluding stress scenarios and rather incorporated mild economic factors.

For example, Citi disclosed that under a net-zero pathway, anticipated losses due to defaults were approximately $10.3 billion, and under a “current policies scenario,” the losses were projected to exceed $7.1 billion.

Additionally, participants have also reported facing considerable difficulties in calculating climate-related financial risks due to data and modelling issues. They highlighted the absence of detailed, uniform data on building features, insurance, and strategies for managing climate risks.

Often, they had to depend on third-party vendors to address these data and modelling deficiencies. This underscores the importance and need for the Fed to work and maintain engagement with data and scenarios providers, to ease banks efforts to develop appropriate models that accurately reflect the severe but plausible climate risks and inform effectively the property market with quality data.

Fed’s Governor Christopher J. Waller claimed in his speech last year that “climate change is real, but I do not believe it poses a serious risk to the safety and soundness of large banks or the financial stability of the United States. […] I want to be careful not to conflate my views on climate change itself with my views on how we should deal with financial risks associated with climate change”.

This indicates that future U.S. climate exercises are not likely to incorporate key upgrades to existing scenario and data models. However, this is crucial to address as most participants from the previous pilot exercise mentioned the latter as key limits to the analysis.

Although banks are able to derive some risks in real estate loans, the assessment could remain limited to orderly scenario, ignoring unidentified severe but plausible tail risks.

To address these gaps, the Fed should integrate severe climate scenarios into their analyses and improve data quality by utilising advanced modelling tools. Partnering with Climate X can further enhance climate risk assessments to bolster banking resilience to climate shocks from the property market.

Although less advanced than its above mentioned peers, the BoC made notable progress, particularly in assessing transition risks since its 2022 scenario analysis exercise.

However, developing capabilities to identify and manage physical climate impacts on banking portfolios, is an essential part of understanding forward-looking risk information, and developing adequate climate mitigation and adaptation strategies, especially to improve the resilience of real estate lending.

On that note, despite the BoC works closely with other regulators such as the Office of the Superintendent of Financial Institutions (OSFI), the banking sector did not make significant improvement on physical risk treatment.

According to Corporate Knights, OSFI evaluates real estate’s physical risk exposure without assigning a financial cost, disregarding climate change and only considering the economic policy response’s effects on future asset values and credit risk.

Like the U.S., this also indicates a reluctance to engage with vital data and methodologies needed to reflect real impacts of climate change on both the banking and property sectors.

From another perspective, it is worth recognising recent development by Canadian financial institutions and ongoing consultation regarding the integration of climate-related financial disclosure, including physical risks disclosure.

Nevertheless, working with various stakeholders like climate data and scenario providers at a developmental level is crucial for effective delivery.

While central banks are gradually incorporating climate risk management into their financial stability frameworks, focusing on forward-looking methodologies and collaborating with climate data providers can significantly enhance the assessment of physical and transition risks on banks and properties.

However, regional approaches clearly vary. The ECB and BoE are making notable progress in upgrading their climate risk assessment capabilities and leveraging new data and modeling tools available.

In contrast, the Fed and BoC are more cautious, particularly in integrating more severe but plausible climate scenarios and detailed data into their financial risk models.

This regional variation underscores the importance of tailored strategies and employing services such as Climate X’s product to effectively capture climate risk impacts on property portfolios and enhance the resilience of the banking sector.