In a recent analysis titled “Examining Banks’ Climate Risk: Key Challenges Identified,” George Gallagher, ESG, Climate Risk, Natural Hazard and Spatial Solutions expert at CoreLogic, along with Kent David, Senior Leader of Analytics Consulting at CoreLogic, delves into the most significant obstacles faced by banks in addressing climate risk. The report focuses on the examination of present climate risks and the Federal Reserve Board’s evaluation of supervised institutions, particularly banks, in effectively handling all significant risks, encompassing those linked to climate change.

According to the report, identifying regions in the United States that offer greater property safety and comprehending the impact of the changing climate on physical risk pose significant challenges for banks and institutions responsible for forecasting future risks associated with real estate investments.

The report highlights that the Federal Reserve Board is currently undertaking a Climate Analysis Exercise, which is scheduled to be completed by July 31, 2023. The purpose of this exercise is to gather insights into the practices employed by large banking organizations in managing climate-related risks.

The Federal Reserve launched a pilot Climate Scenario Analysis exercise, providing instructions to six participating US banking organizations. They must submit data and documentation on their climate risk management practices, enabling them to better understand the expectations set by the Federal Reserve.

The author makes note of five significant points regarding climate risk management, which can be summarized as follows:

1. Non-credit-based assessment of physical risks: Banks have rarely been tasked with evaluating climate-related physical risks, which results in a lack of prepared methodologies for such assessments.
2. Terminology discrepancies: The absence of a common language among experts creates a need for establishing standardized terminology within the industry.
3. Financial quantification of physical risk: Determining the value of the collateral and identifying the necessary parameters for adjusting its worth are essential components in assessing physical risk.
4. Understanding default probability: The inclusion of physical risk and transition risk necessitates a reevaluation of the definition of default for most banks.
5. Distinct nature of climate risk variables: Climate risk variables differ significantly from credit risk variables. Properly quantifying these climate-related events requires considering various factors such as geographic distribution, time horizons, and modeling future scenarios encompassing evolving climate risks in different severity levels. While this complexity adds challenges to calculations, they are not insurmountable.