If not properly managed, climate risks could trigger systemic crises with significant impacts on the global financial system and the real economy. To prevent such a scenario, institutions and companies must improve how they evaluate both physical and transition risks.
This is the focus of a recent report by the Financial Stability Board (FSB), an organization that coordinates national financial authorities and international regulatory bodies to promote policies that enhance financial stability.
At the core of the report is a new analytical framework and a list of metrics designed to assess vulnerabilities associated with the climate crisis. The approach is forward-looking, aiming to identify risks to stability well in advance, particularly those caused by overlapping crises and compounded effects triggered by climate-related factors.
“Climate shocks activate typical vulnerabilities in financial stability assessments, such as credit, market, and liquidity risks, but they are more complex to analyze due to their nature and uncertainties around timing and scale,” the report explains. “The analytical framework outlines how physical and transition climate risks can be transmitted and amplified within the global financial system.”
One case illustrating these risks is the shifting landscape of insurance coverage for climate-related events. For example, California’s wildfires have disrupted the state’s insurance market in recent years, influencing insurer policies across other markets. These cascading effects ripple through other sectors of the economy and finance.
Climate Risks: FSB’s New Metric
The FSB identifies three key categories of metrics to assess climate risks:
- Proxies: Early indicators of climate risk drivers.
- Exposure Metrics: Tools for evaluating the extent of financial exposures, both direct and indirect.
- Risk Metrics: Quantifications of impacts on individual institutions and the global financial system.
Proxies provide early signals of potential drivers of both physical and transition risks. They include information on the likelihood and severity of hazards or the potential misalignment of greenhouse gas emissions trajectories between projected transition pathways and jurisdictional benchmarks.
Exposure metrics help gauge how identified climate risk drivers, as indicated by proxies, could propagate through the financial system and impact various sectors—both financial and non-financial. These metrics draw from a mix of climate-specific, sectoral, and financial data.
Risk metrics leverage information from proxies and exposure metrics to quantify the extent of financial impacts as climate shocks cascade through the system, interacting with existing vulnerabilities. Examples of these risk metrics include portfolio sensitivity to climate factors, valuations, leverage, and liquidity transformation.