How climate risk rules are reshaping finance

Climate risk goes mainstream

The financial world is starting to wake up to the realities of climate change. 

Banks and companies already disclose all kinds of financial and risk information to their investors (think annual and quarterly reports). But they rarely report on climate or sustainability data, or if they do it’s in an ESG Report that often comes out separately and later than financials. 

Canada’s main financial regulator, the Office of the Superintendent of Financial Institutions (OSFI), is introducing new guidelines that require Canada’s largest banks and insurers to integrate climate risk into their businesses. Canada isn’t alone on this front: countries around the world are recognizing that climate change is happening and will have real, material impacts on their assets and investments around the world. 

More countries are adopting regulations that require financial institutions and businesses to measure these risks and include them in their governance, strategy and risk management practices. 

This might sound disconnected from on-the-ground efforts to address climate change. But climate risk brings the impacts of climate change into mainstream investing and financial markets. This has the potential to change investor behaviour as they better understand their exposure to extreme weather or stranded assets in their portfolio - and start pricing in the impacts of future climate change.

The context: What is climate risk?

Climate risk is all about how we deal with the future potential impacts of climate change on business, society and ecosystems. 

The Task Force on Climate-Related Financial Disclosures (TCFD) has worked on a framework to deal with climate risk since 2015 to promot more informed investment, lending and underwriting decisions. It also touches on the stability of the global financial system given the potential exposure to “carbon-related assets” and climate risks.

We’ve talked about climate risk at a high level, but it’s useful to break it down a bit further: 

Physical risk

Physical risk is all about the risk posed to physical assets by climate change. It includes acute risks like flooding, wildfires, and storms, or chronic risks that are driven by long-term changes - drought, sea level rise, or higher temperatures. 

If you’re a bank or business, this looks like damage to the assets you own, disruptions in your supply chains, employee safety issues, or lower production capacity. 

Solutions like RiskThinking.AI are combining big data, advanced analytics and AI to build out these models (more on RiskThinking shortly).

This can feel somewhat theoretical (risk inherently deals with “what if?”) but physical risks are being realized in real time: Spain’s “climate leave” policy to protect employees from travelling during extreme weather; lower power generation from hydropower plants in B.C. and Quebec; or more frequent and damaging storms like Hurricane Milton.

Transition risk

Transition risk deals with the transition to a low-carbon economy. It’s things like how policy might change, legal exposure and liabilities, technology changes and risks, market and consumer preferences, and more. It’s all about how well an organization manages its own transition and responds to the pace of change around it. 

Calgary-based Arbor is helping businesses and financial institutions manage their transition risks with better reporting on supply chain emissions. Their platform helps businesses manage their carbon footprint, but can also give financial institutions insight into the emissions in their investment portfolios.

It’s worth noting here that it’s not all pro-climate action. Organizations will also be managing the risk of failure or high costs in adopting new technologies, the potential for carbon prices to go down, or the cost of critical minerals going up.

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What’s changing: Climate risk in finance

The first domino is OSFI’s Guideline B-15, a new set of rules on climate risk disclosure for federally-regulated financial institutions. It requires banks and insurers to integrate climate risk into their governance, strategy, and risk management practices, including:

• Reporting on how exposed they are to climate risk

• Impacts on long-term strategy

• Climate transition plans

• Which metrics and targets they’re tracking

• Running climate scenarios

Scenario modelling is key because it forces organizations to think about a range of outcomes, rather than a single number. For example, “sea levels will rise by 1 meter” feels concrete, but the potential range could be ½ a meter all the way to 6 meters. 

These rules take effect for “systemically important” banks and insurers at the end of 2024, and all other institutions at the end of 2025. The AMF, Quebec’s financial services regulator, is introducing similar plans for provincially regulated institutions.

Big business

Earlier this year, the federal government shared that it’s going to extend climate-related financial disclosures to large businesses.

We don’t know what these rules will look like yet, but will most likely use recommendations from the Canadian Sustainability Standards Board (CSSB) and ISSB, and cover the same ground as B-15. The CSSB rules also include “sustainability-related” risks and opportunities like water use, the sustainability of natural resource use, and more.

The CSSB explicitly recognizes the fact that the economy sits within a larger ecosystem: 

Small- and medium-sized businesses will be exempt, but the government wants to introduce voluntary guidelines to encourage more disclosures.

Canada is one of many nations adopting climate disclosure rules as the world recognizes the material impact that climate change will have on the financial system and global economy:

• The EU’s Corporate Sustainability Reporting Directive (CSRD) came into effect in 2023, requiring businesses (including some non-EU companies operating in the EU) to disclose environmental and social impacts.

• The U.S. SEC also introduced climate disclosure rules, taking effect EOY 2025, that include Scope 1 and 2 emissions, the impact of climate risk on the company, and climate-related targets and goals

These new rules are still early and at risk of being watered down or rolled back, but still represent a significant step toward integrating climate change into the financial system. 

Together, markets requiring climate risk disclosures by 2025 cover 56% of the global economy.

Turning regulations into action

Creating regulations is one thing - putting them into action is another. Banks, insurers and the ecosystem of lawyers, consultants, and accountants that do a lot of the heavy lifting for financial disclosures face some challenges in meeting the moment:

First, companies and financial institutions need to get access to data that’s buried deep in supply chains and spread across the globe. And they need to do it reliably because it’s part of their financial disclosures - getting that wrong can lead to some major penalties. 

Second, once they have data on their climate risks, companies then need to make sense of it and turn it into real insights. There’s a huge data and analytics component, but also climate literacy. From the board to finance analysts, organizations will need a new set of skills to do this analysis. 

Spotlight: RiskThinking.AI

Toronto’s RiskThinking.AI has developed a climate data and analytics platform to help organizations synthesize huge amounts of data on climate risks into actionable insights. 

At the core of RiskThinking’s solution is a digital twin of the Earth with data points on physical assets and climate hazards around the world. They’ve modelled over 5 million business locations across 80,000 companies to help organizations understand the climate-related risks for their assets and supply chains. This lets users ask a question involving millions of data points and stress tests in seconds, a task that would require hundreds of hours otherwise. 

RiskThinking is taking on the radical uncertainty of climate change by taking a more scenario-based approach. To do this, they combine data on physical assets and risks with expert insights to generate risk scores based on multiple scenarios. So rather than saying “sea levels at this location will rise by 1 foot”, their scores look at probabilities and ranges: sea level rise will be between 1 foot and 9 feet, and a 60% probability of 5 feet. 

This approach helps integrate “black swan” events by looking not just at the averages, but at the long tail of possible outcomes. It also leads to smarter decisions. Rather than relying on a forecast of 3 inches and deciding not to build a sea wall, you can manage that risk and choose to build a smaller sea wall that can be extended in the future. 

You can see RiskThinking’s data in action by chatting with their public Ask RiskThinking chatbot.

Beyond financial institutions, RiskThinking’s founder Dr. Ron Dembo believes this kind of analysis could be a game changer for cities: “Suddenly every regulator, every city, every municipality, every government has data and tools that enable measurement. You could aggregate it across the country, and you'd have a digital twin of Canada. In other words, you have a digital story for Canada's climate future.”

Pricing the future

Integrating climate risk into how the financial system makes decisions has huge potential to shift how capital is deployed and which projects are funded. Without it, exposure to climate risk is a black box, making it easy to discount the future impacts of climate change and prioritize short-term thinking. 

Widespread exposure to climate risk could also lead to more instability in the financial system. Regulators like OSFI are increasingly pushing the financial sector to balance short-term profit motives with long-term climate considerations.

To meet the moment, we’ll need new mental models and tools. Traditional risk management relies heavily on past data, but it’s becoming less relevant as the frequency and severity of extreme weather increases and the future looks less and less like the past.

New approaches like scenario analysis, big data, and AI can help uncover the risks buried deep in supply chains and make better decisions about an uncertain future.

Dive deeper on climate risk with these resources:

• Explore climate risk data with Ask RiskThinking

• The EPA’s guide to climate risks

• Primer on Financed Emissions from the Institute for Sustainable Finance

• Scorecard for Canadian banks from Investors for Paris Compliance

• Corporate Climate Disclosure Has Passed a Tipping Point