Climate risk has rapidly emerged as one of the most significant new risk categories for financial institutions. Understanding it is increasingly important for both FRM exam success and practical risk management.

Two Channels of Climate Risk

Physical Risk

Direct damages from climate-related events:

  • Acute: Hurricanes, floods, wildfires — causing asset damage and business disruption
  • Chronic: Rising sea levels, changing temperatures — gradually eroding asset values and productivity

Transition Risk

Financial impacts from the shift to a low-carbon economy:

  • Policy: Carbon taxes, emissions regulations, energy mandates
  • Technology: Renewable energy disrupting fossil fuels, EV adoption
  • Market: Changing consumer preferences, investor sentiment
  • Reputational: Stakeholder activism, greenwashing scrutiny

Transmission to Financial Risk

Climate risk transmits through traditional channels:

  • Credit Risk: Borrowers in exposed sectors face higher DEFAULT risk
  • Market Risk: Repricing of carbon-intensive assets
  • Operational Risk: Physical damage to facilities, supply chain disruption
  • Liquidity Risk: Fire sales of stranded assets, funding market disruptions

Regulatory Landscape

TCFD (Task Force on Climate-related Financial Disclosures)

Framework for disclosure across four pillars:

  1. Governance
  2. Strategy
  3. Risk Management
  4. Metrics and Targets

Climate Stress Testing

Central banks and regulators are conducting climate stress tests:

  • BoE Climate Biennial Exploratory Scenario (CBES)
  • ECB Climate Stress Test
  • Network for Greening the Financial System (NGFS) scenarios

ISSB Standards

The International Sustainability Standards Board has issued global sustainability disclosure standards, creating a baseline for climate-related financial reporting.

Challenges for Risk Managers

  1. Long time horizons: Climate risk materializes over decades, beyond typical risk models
  2. Data gaps: Limited historical data for forward-looking climate scenarios
  3. Model uncertainty: Climate models have significant uncertainty
  4. Interconnections: Climate risk interacts with all other risk types

Stranded Assets

Assets that may lose value prematurely due to the energy transition:

  • Fossil fuel reserves that cannot be burned
  • Coal-fired power plants becoming uneconomic
  • Carbon-intensive industrial facilities

Practical Steps for Risk Managers

  1. Assess portfolio exposure to physical and transition risk
  2. Integrate climate scenarios into stress testing
  3. Develop climate-related metrics and KPIs
  4. Engage with counterparties on climate strategy
  5. Build internal capabilities and data

Prepare for climate risk questions in the FRM exam with our current issues practice tests!