How do financial institutions integrate climate risks?
The Federal Reserve Bank of New York provides in its « Climate Stress Testing » report an in-depth analysis of the financial implications of climate change and the need for climate stress testing.
The main takeaways of the study include:
- Financial institutions should understand both physical (direct impact of climate change) and transition (the shift towards a low-carbon economy) risks associated with climate change.
- Investment professionals perceive regulatory and technological risks as more significant than physical risks, even though physical risks are expected to become more important over longer time horizons.
- Almost 90% of central banks' exercises explored the implications of transition risk, while about 67% analyzed the effects of physical risks.
- Climate change can affect stock prices: stocks whose returns are more negatively correlated to changes in long-run historical temperatures have earned higher returns than stocks that are less correlated.
- Municipal bond markets are significantly affected by physical climate risk exposure, with issuers in locations exposed to sea level rise having significantly higher borrowing costs than unexposed issuers, especially for long-maturity bonds.
- Climate risks can also be a source of liquidity risk through their effect on banks' deposit and lending behaviour.
This study provides a comprehensive understanding of the financial risks associated with climate change and highlights the need for climate stress testing to assess the resilience of financial institutions to these risks.
Understanding how investors form their beliefs about climate change and how these beliefs affect asset prices can provide further valuable insights to fine-tune investment strategies.