Climate change and the financial system: how is this complex relationship being managed?

A polar bear on a tiny piece of ice, wildfires, floods:  this is what comes to mind when thinking about the effects of climate change. However, this is only the starting point since the effects on the environment will have an impact on the economic and financial system. Therefore, climate change is a phenomenon that needs to be considered also by the financial sector. In fact, the normal risk framework does not consider certain factors and, as a result, it could be inadequate to handle risks coming from climate change. These have been classified in physical risks and transitional risks. While the firsts concern the modifications of the climate regimes and, consequently, the modifications of the operations of organizations, the seconds are a result of industries trying to lower their contribution to climate change. The subsequent paragraphs will explore why it is challenging to consider these risk factors and how this problem is being handled at a global level.

Including climate change in the usual risk management framework is particularly challenging for several reasons. Firstly, since it is an unprecedented phenomenon there is no historical or statistical data available. Secondly, the risk is unmeasurable and unquantifiable because of the radical uncertainty that characterized a lot of climate change consequences. Thirdly, classic economic theories use a normal distribution of risks, but this does not apply to climate change consequences since they will consist of a lot of extreme events. Fourthly, given the fact that understanding the world is really difficult, economic agents use a simplified model to decide how to act (this is called bounded rationality), but this model could be too simplistic and make them make the wrong choice. Moreover, since all economic agents are using the same models, they could all make the same mistakes. Fifthly, while the worst climate change consequences will happen in the distant future, financial actors consider a short period of time while making their decisions. This discrepancy in time-horizons is detrimental to the effort to mitigate climate change since investors are not incentivised to consider the effects on climate of the company they are investing in. Given all that, climate-related risk is probably mispriced right now, therefore financial actors are taking misinformed decisions and financial institutions are overexposed to risk (Hugues & Chenet, 2021). 

Furthermore, since climate-related risks are global in nature, they need to be addressed by a joint effort of all the main economies of the world. For this reason, in 2021 a roadmap for addressing climate-related financial risks has been published by the Financial Stability Board which is an international organization created by the London G20 (2009) to improve the stability of the international financial system by sharing information and cooperating internationally (Financial Stability Board-Fsb, s.d.). The G20 is an informal forum of 19 countries and two regional bodies which includes all the principal industrialised and developing economies and has the objective of discussing international economic, financial stability and other topics. For example, the forthcoming G20, which will take place in South Africa this year, has solidarity, equality and sustainability as a theme (Overview, s.d.). Moreover, it is important to underline that, because of its informal nature, when the G20 created the FSB, it set out its activities in the FSB Charter and specified that none of its decisions are binding or able to give rise to any legal right or obligation. Nevertheless, several actions have been undertaken to implement the plan outlined in the roadmap, as it has been observed in the update published by the FSB this year. 

The 2021 Roadmap for addressing climate-related financial risks was composed of four blocks: firm-level disclosures, data, vulnerabilities analysis and regulatory and supervisory practices and tools. The implementation of the first block mainly concerns making firms applying the 2023 International Sustainability Standards Board (ISSB) standards (Financial Stability Board, 2025). The ISSB is one of the two standard setting boards of the IFRS, which is a not-for-profit organization created to provide accounting and sustainability disclosure standards that are globally accepted (International Sustainability Standards Board, s.d.). Since these standards are not binding it is important that national jurisdictions include them into local requirements, and some steps have been taken in that direction. Moreover, international sustainability assurance standards and other sets of standards have been created recently in order to improve trust in sustainability reporting information. 

The second block regarding having better data to support analysis of climate-related financial risk has been addressed by different initiatives: the creation of climate risk dashboards; the identification of data needed to make forward-looking metrics operational; the pilot project of the International Monetary Fund to collect available data; and several other initiatives to improve the data available. 

The third block is about being able to conceptualise and monitor vulnerabilities and, regarding this, conceptual frameworks and scenario-based analysis have been developed. An important contribution has been the FSB analytical framework and toolkit which give a broad perspective by focusing on possible transmissions of physical and transition risks to the financial system. This is particularly relevant because vulnerability analysis tends to focus on specific topics and issues. The update also notices an increase in scenario analysis exercises (Financial Stability Board, 2025). Scenario-based analysis, since it is a “what if” analysis under a specific possible future, is especially useful in this context because it is impossible to attribute to a climate-related scenario a probability of occurrence and, therefore, other kinds of analysis are useless. Scenario-based analysis instead permits to stress-test the readiness of the financial system in relation to possible happenings (Hugues & Chenet, 2021). 

The fourth block concerns developing regulatory and supervisory practices and tools. In this regards the update notice that many bodies made possible the incorporation into existing risk classifications, sectoral regulatory and supervisory frameworks of climate related risks. Moreover, the Network for Greening the Financial System is identifying and sharing best practices for supervisory authorities. However, it is also underlined that most countries have been focused on collecting climate data but there are still gaps that make evaluating its quality and comparability difficult. To fill these gaps, it is being explored the possibility of using information reported by firms in their transition plan, but this would entail making firms respect certain conditions (transparency, credibility, consistency and comparability) since right now the rules on the drafting of such documents do not consider a wider use of that data. The update also underlines that even nature-related financial risk, which is the risk created by damaging ecosystems, is being explored, also in relation to its connection to climate-related risk. Finally, regarding ongoing work, there are three main directions: helping implementation of regulatory and supervisory practices in jurisdictions that need that assistance; working on facilitating the operationalisation of transition plans and their supervision; adopting measures and addressing insurance protection gaps to increase the resilience to physical climate-related risk (Financial Stability Board, 2025). 

Finally, it is possible to notice how at a global level an effort to overcome the challenges that taking into consideration climate-related financial risk entails is being made. However, it also stands out how it is a really demanding task and, therefore, everything that is being done could easily be insufficient.

Bibliography

Financial Stability Board. (2025, July 14). FSB Roadmap for Addressing Financial Risks.

Financial Stability Board-Fsb. (s.d.). Tratto da MEF dipartimento del tesoro: https://www.dt.mef.gov.it/it/attivita_istituzionali/rapporti_finanziari_internazionali/organismi_europei/fsb/

Hugues, & Chenet. (2021). Financial Risk Management and Modeling. cham switzerland: Springer International Publishing AG.

International Sustainability Standards Board. (s.d.). Tratto da IFRS: https://www.ifrs.org/groups/international-sustainability-standards-board/

Overview. (s.d.). Tratto da G20 South Africa 2025: https://g20.org/about-g20/overview/