Introduction: Why Climate Risks Break the Risk Management Narrative

When banks think about risk, they traditionally think in categories: credit, market, liquidity, operational. These risks are well understood, modelled with decades of historical data, and treated as core to financial management. Climate risks, however, defy these conventions. They are forward-looking, nonlinear, and systemic. And because they don’t behave like traditional risks, they demand a fundamentally different approach to understanding and managing exposure.

Physical and Transition Risks: Two Interlinked Forces

Climate-related financial risks generally fall into two categories: physical risks and transition risks. Institutions like the Network for Greening the Financial System (NGFS) and the Task Force on Climate-related Financial Disclosures (TCFD) have been instrumental in clarifying these concepts.

Physical risks stem from the direct impact of climate change: floods, wildfires, heatwaves, and rising sea levels. They can destroy assets, disrupt operations, displace populations, and ultimately impair economic output.

Transition risks arise from the shift towards a low-carbon economy. Changes in regulation, technology, and market preferences can quickly alter the value of assets, challenge business models, and create new risks for lenders and investors alike.

Climate risk is not limited to global warming alone, it includes the broader environmental degradation that interacts with climate change, such as biodiversity loss, deforestation, and pollution. These are not just ecological issues; they are structural forces that can alter asset values, business models, and market dynamics across the economy.

What makes climate risk different is not just its scope, it is the interconnectedness and speed at which these two types of risk can reinforce each other, creating cascading effects across sectors and regions. These risks ultimately translate into financial exposures, from rising defaults and operational losses to declining asset values and credit downgrades.

Why Traditional Risk Models Aren’t Enough 

Traditional financial risk models are built on one foundational assumption: that the future will resemble the past. Losses, defaults, and market shocks are modelled based on historical volatility and performance data.

Climate risks break this logic. They are inherently forward-looking: the most severe consequences of today’s emissions will unfold over decades, not quarters. They are also nonlinear: small changes in temperature can lead to disproportionate increases in damages, and crossing certain thresholds, like a global temperature rise beyond 1.5°C, can trigger irreversible systemic shifts.

Historical data simply does not capture the compounding effects of longer droughts, higher sea levels, more frequent flooding, or sudden regulatory changes. Without incorporating forward-looking climate scenarios, banks are effectively blind to a growing portion of the risks embedded in their portfolios.

From Theory to Reality: Climate Risks Are Here

The COVID-19 pandemic provided a real-world lesson in how non-linear, systemic risks can upend economies in ways that traditional models failed to predict. Climate change poses similar, but even more profound, systemic threats.

Take the example of the 2021 floods in Germany and Belgium. Within hours, entire communities were submerged. The financial aftermath was significant: insurance claims reached billions of euros, infrastructure repairs strained public budgets, and property values in flood-prone areas dropped sharply. Banks with mortgage portfolios concentrated in affected regions faced unexpected spikes in non-performing loans and collateral impairment. For some institutions, the flood turned into an unanticipated credit event, not because their models failed, but because the models never considered climate as a variable.

These events are not anomalies. They are early signals of a broader trend: climate risks are no longer hypothetical, and their financial consequences are escalating.

Transition risks are also becoming real. In 2022, Société Générale exited its Russian oil and gas business, not only due to sanctions, but as part of a broader move to align its portfolio with ESG expectations from stakeholders. The €3 billion write-down associated with selling its Rosbank unit shows that climate-aligned decisions can have immediate financial consequences.

Climate Risk Drives Traditional Financial Risk

Banks should no longer treat climate risk as a standalone category. It acts as a risk driver, intensifying existing types of financial risk:

• Credit risk: A flood can impair a borrower’s ability to repay their mortgage. Carbon-intensive firms may face higher operating costs or become unprofitable.

• Market risk: Asset prices shift as investors react to policy changes or physical damages.

• Operational risk: Weather extremes can close branches or damage data centers.

• Liquidity risk: Abrupt policy shifts or climate disasters can cause funding stress.

• Reputational or legal risk: Lawsuits or public backlash against banks seen as financing polluting activities can erode trust and market value.

These channels are already acknowledged by the ECB, BaFin, and EBA, and are increasingly being integrated into supervisory expectations.

Schematic illustration of transmission from environmental risks to financial risks

Figure 1: NGFS - Transmission channels from climate risks to financial risks.

Climate Risk Scenarios: The Difference Between 1.5°C and 3°C

The NGFS climate scenarios make the systemic nature of these risks visible. Their projections show how different policy choices and warming trajectories could affect sectors like energy, real estate, agriculture, and transportation. Under a “Delayed Transition” scenario, for example, GDP losses could be significantly higher and asset price volatility more severe compared to an orderly transition.

The ECB’s 2022 climate stress test underscored this materiality: 41 major European banks projected losses exceeding €70 billion under short-term disorderly transition and severe physical risk scenarios. The exercise also exposed major data and modeling gaps, especially for smaller banks that were not included.

The difference between a 1.5°C and a 3°C world is not incremental, it is transformational. In one, the financial system adapts gradually. In the other, it lurches through periods of acute disruption.

Positioning of scenarios is approximate, based on an assessment of physical and transition risks out of 2100

Figure 1: Overview of NGFS scenarios from ECB.

Why This Matters for Banks

In Germany, many smaller and mid-sized banks are only beginning to explore climate risk integration into their core frameworks. As a result, there is a danger of underestimating the urgency. Climate risks are still often seen as reporting issues. But in reality, they affect credit quality, loan pricing, investment strategy, and capital requirements.

The consequences of failing to adapt will not remain theoretical. They will materialize in impaired asset values, funding pressures, reputational damage, and supervisory scrutiny. Banks must recognize that climate risks are no longer distant, they are already reshaping financial landscapes.

Forward-Looking Risk Management

Understanding climate risks is not about predicting the weather. It is about recognizing structural shifts that will shape asset values and creditworthiness for decades to come. Traditional models based solely on historical data are no longer sufficient.

What your bank can start doing today:

• Map exposures to high-risk sectors or geographies

• Use NGFS scenarios for basic stress testing

• Assign oversight of climate risks at the board or executive level

• Start integrating climate considerations into loan origination and investment decisions 

At Atlas Metrics, we help banks assess their climate risks and integrate forward-looking climate scenarios into their risk management frameworks, ensuring that they are prepared not just for today’s challenges, but for tomorrow’s realities. Because ignoring climate risks is no longer a neutral choice, it's a strategic blind spot.