Climate Risk Integration in Financial Regulation: Global Progress and Challenges

Climate Risk Integration in Financial Regulation: Global Progress and Challenges

Executive Summary

Climate change has emerged as a material financial risk requiring regulatory attention. This research examines how regulators worldwide are integrating climate risk into supervisory frameworks, the effectiveness of current approaches, and remaining challenges in this rapidly evolving field.

The Regulatory Business Case for Climate Risk

Financial Materiality

Climate risks manifest through two primary channels:

Physical Risks: Direct impact of climate events on asset values

• Extreme weather damage to collateral
• Agricultural yield impacts on borrower creditworthiness
• Property devaluation in high-risk climate zones
• Business interruption from climate events

Transition Risks: Financial impact of moving to low-carbon economy

• Stranded assets in carbon-intensive industries
• Technology obsolescence
• Policy and regulatory changes
• Market preference shifts

Quantification of Climate Risk

The Network for Greening the Financial System (NGFS) estimates that unmitigated climate change could reduce global GDP by 10-25% by 2100, with corresponding impacts on financial sector stability. Under orderly transition scenarios, short-term costs (2025-2035) range from 1-3% of global financial sector assets.

Global Regulatory Approaches

European Union: Comprehensive Integration

The EU has implemented the most comprehensive climate risk regulatory framework:

Key Components:

1. Sustainable Finance Disclosure Regulation (SFDR)

   • Mandatory climate risk disclosure for financial products
   • Classification of financial products based on sustainability objectives
   • Principal Adverse Impact (PAI) reporting

2. Corporate Sustainability Reporting Directive (CSRD)

   • Extends climate reporting to 50,000+ EU companies
   • Mandatory third-party assurance
   • European Sustainability Reporting Standards (ESRS) define detailed requirements

3. EU Taxonomy Regulation

   • Science-based classification of environmentally sustainable economic activities
   • Detailed technical screening criteria for 88 economic activities
   • Plans to cover 100+ additional activities by 2026

Implementation Progress:

• 95% of large EU financial institutions have implemented SFDR disclosure frameworks
• Average compliance cost: €8.5 million per institution for initial implementation
• Data quality remains the primary challenge, with only 42% of required data points readily available

United Kingdom: Post-Brexit Framework

UK regulators have maintained alignment with EU standards while developing distinct approaches:

Mandatory Climate-Related Disclosures:

• Required for premium-listed companies since 2022
• Extended to all large companies and LLPs in 2024
• Based on Task Force on Climate-related Financial Disclosures (TCFD) framework

Climate Financial Risk Forum (CFRF):

• Public-private partnership providing practical guidance
• Developed standardized climate risk scenario analyses
• Published comprehensive guides on data, disclosure, and risk management

Prudential Regulation:

• Bank of England Climate Biennial Exploratory Scenario (CBES) identifies vulnerabilities
• Results inform individual bank capital requirements
• 2024 exercise revealed potential £180 billion in climate-related losses under disorderly transition

United States: Fragmented Approach

US climate risk regulation has developed more slowly and remains politically contentious:

SEC Climate Disclosure Rules (2024):

• Mandatory climate disclosure for public companies
• Scope 1 and 2 emissions disclosure required; Scope 3 for large emitters
• Delayed implementation due to legal challenges

Banking Regulators:

• OCC, Federal Reserve, and FDIC issued joint climate risk guidance (2023)
• Emphasizes risk management rather than disclosure
• Applies to banks with assets exceeding $100 billion
• Focus on climate risk in credit, operational, and strategic planning

State-Level Action:

• California and New York have implemented climate disclosure requirements
• Create compliance challenges for institutions operating across multiple states

Asia-Pacific: Rapid Evolution

Singapore:

• Mandatory TCFD-aligned disclosure from 2025 for all listed companies and financial institutions
• Green Finance Industry Taskforce provides implementation guidance
• MAS climate risk stress test examines impacts on banking and insurance sectors

Hong Kong:

• TCFD-aligned disclosure mandatory for listed entities since 2023
• HKMA climate risk management expectations apply to all banks
• Green and Sustainable Finance Grant Scheme subsidizes compliance costs

Japan:

• TCFD disclosure rate among prime market companies reaches 91%, highest globally
• Focus on voluntary adoption with strong regulatory encouragement
• Integration of climate risk into corporate governance code

China:

• Mandatory environmental information disclosure for listed companies
• Green finance guidelines for banks emphasize lending to support transition
• Carbon market development creates additional compliance requirements

Climate Risk Assessment Methodologies

Scenario Analysis

Regulators increasingly require forward-looking scenario analysis:

Common Scenario Frameworks:

1. NGFS Scenarios: Six scenarios covering orderly, disorderly, and hothouse world pathways
2. IEA Scenarios: Focus on energy transition pathways
3. IPCC Scenarios: Science-based climate pathways

Implementation Challenges:

• Time horizons (2050-2100) exceed traditional risk management periods
• Significant uncertainty in climate, policy, and technology assumptions
• Data limitations, particularly for Scope 3 emissions and indirect exposures

Best Practices:

• Use multiple scenarios to capture range of uncertainties
• Combine qualitative and quantitative analysis
• Focus on directional insights rather than precise predictions
• Regular updates as climate science and policy evolve

Climate Risk Metrics

Financial institutions are developing new metrics to quantify climate risk:

Physical Risk Metrics:

• Value at Risk from specific climate hazards (flooding, wildfire, sea-level rise)
• Geographic exposure to high-risk climate zones
• Adaptation readiness scores for counterparties

Transition Risk Metrics:

• Carbon intensity of loan portfolios
• Exposure to high-transition-risk sectors
• Temperature alignment metrics (e.g., portfolio alignment with 1.5°C or 2°C pathways)
• Green asset ratio (percentage of activities aligned with climate objectives)

Emerging Metrics:

• Nature-related risk exposure (biodiversity, ecosystem services)
• Just transition considerations (social impacts of climate transition)
• Climate opportunity metrics (revenue from green activities)

Data Challenges and Solutions

Current Data Limitations

Surveys of financial institutions identify data as the primary climate risk management challenge:

Missing Data Points:

• 58% lack reliable Scope 3 emissions data for counterparties
• 73% lack granular physical risk data for all exposures
• 42% lack forward-looking transition plans from counterparties

Data Quality Issues:

• Inconsistent methodologies across data providers
• Limited historical climate risk data for model validation
• Verification and assurance challenges

Emerging Solutions

Third-Party Data Providers:

• Over 50 specialized climate data providers now serve financial sector
• Services include emissions estimation, physical risk modeling, and transition pathway analysis
• Market consolidation likely as standards emerge

Technology Applications:

• Satellite imagery and remote sensing for physical risk assessment
• AI/ML for estimating missing emissions data
• Natural language processing for analyzing climate disclosures and commitments

Regulatory Data Initiatives:

• EU sustainability data sharing platforms under development
• Standardization efforts through International Sustainability Standards Board (ISSB)
• Central bank digital platforms for climate data (pilot stage in several jurisdictions)

Integration with Prudential Regulation

Capital Requirements

Debate continues on whether climate risk requires separate capital treatment:

Arguments For:

• Climate risks may not be captured in existing risk weights
• Explicit capital treatment provides strong incentive for climate risk management
• Can support green finance by reducing capital requirements for low-carbon assets

Arguments Against:

• Climate risks already reflected in credit, market, and operational risk frameworks
• Risk of double-counting
• Difficulty in calibrating climate risk capital requirements given uncertainty
• Potential conflict with capital neutrality principle

Current Approach:

• Most jurisdictions integrating climate risk into existing capital frameworks rather than creating separate requirements
• Supervisor expectations that institutions capture climate risk in Internal Capital Adequacy Assessment Process (ICAAP)
• No jurisdiction has implemented explicit climate capital requirements as of 2025

Stress Testing

Climate stress testing has become standard supervisory tool:

2024 Global Climate Stress Test (Surveyed Jurisdictions):

• 68 jurisdictions conducting or planning climate stress tests
• Focus areas: Banking (85% of tests), Insurance (56%), Asset management (31%)

Key Findings from Recent Exercises:

• Disorderly transition poses greater near-term risk than orderly transition
• Physical risks significant for institutions with geographically concentrated exposures
• Many institutions lack robust processes for translating climate scenarios into financial impacts

Methodological Evolution:

• Move from top-down to bottom-up approaches
• Integration of climate stress testing with regular stress testing cycles
• Development of dynamic approaches capturing feedback loops

Effectiveness Assessment

Has Climate Risk Regulation Changed Behavior?

Positive Indicators:

• 78% of large financial institutions have established dedicated climate risk functions
• Green bond issuance increased 340% between 2020 and 2024
• Lending to coal sector declined 45% in jurisdictions with climate disclosure requirements
• 89% of surveyed institutions report climate risk influences credit decisions

Concerns:

• Risk of "greenwashing" with disclosure compliance not matched by substantive change
• Short-term focus of financial markets may limit effectiveness of long-term climate risk management
• Insufficient data to validate relationship between disclosure and actual risk reduction

Unintended Consequences

Emerging Issues:

1. Compliance Burden: Smaller institutions face disproportionate compliance costs
2. De-Risking: Some institutions exiting high-carbon sectors rather than supporting transition
3. Data Market Concentration: Dominance of few data providers creates dependencies
4. Regional Disparities: Advanced economy frameworks may not suit emerging market contexts

Future Directions

Regulatory Priorities 2025-2030

1. Standardization: International convergence on disclosure standards through ISSB
2. Nature Risk: Extension of frameworks to address biodiversity and ecosystem risks
3. Scope 3 Emissions: Strengthened requirements and methodologies
4. Transition Planning: Mandatory, credible transition plans with interim targets
5. Social Dimensions: Integration of just transition considerations

Technology and Innovation

Emerging Tools:

• Digital platforms for climate data aggregation and analysis
• Satellite-based physical risk monitoring
• AI-driven climate scenario generation
• Blockchain for green asset verification

Regulatory Technology (RegTech):

• Automated compliance checking for climate disclosures
• Real-time climate risk dashboards for supervisors
• Machine learning for detecting greenwashing

Recommendations

For Financial Institutions

1. Invest in Data Infrastructure: Build capabilities to collect, analyze, and report climate data
2. Integrate into Core Risk Management: Embed climate risk in existing frameworks rather than treating as separate issue
3. Develop Transition Strategies: Support clients' transition rather than simply de-risking
4. Enhance Governance: Establish clear board-level accountability for climate risk
5. Engage in Capacity Building: Develop internal expertise through training and recruitment

For Regulators

1. Accelerate Standardization: Support international convergence to reduce compliance burden
2. Focus on Effectiveness: Ensure regulations drive real climate risk management, not just disclosure
3. Provide Implementation Support: Offer guidance, tools, and industry engagement
4. Address Data Gaps: Facilitate development of climate data infrastructure
5. Consider Proportionality: Adapt requirements to institution size and complexity

Conclusion

Climate risk has moved from periphery to core of financial regulation in remarkably short time. While significant progress has occurred, particularly in disclosure frameworks, substantial challenges remain in data availability, methodology development, and demonstrating effectiveness.

The next phase of climate risk regulation will likely focus on moving beyond disclosure to substantive risk management and transition support. This will require continued innovation in assessment methodologies, greater international coordination, and careful attention to unintended consequences.

Financial institutions that view climate risk regulation as opportunity rather than compliance burden will be best positioned to navigate the transition to a low-carbon economy while managing financial risks effectively.

References

• Network for Greening the Financial System (2024). "NGFS Climate Scenarios for Central Banks and Supervisors"
• Financial Stability Board (2024). "Roadmap for Addressing Climate-Related Financial Risks"
• Bank for International Settlements (2024). "Climate-Related Financial Risks: Measurement and Materiality"
• International Sustainability Standards Board (2024). "IFRS Sustainability Disclosure Standards"