Deep dive: climate risk in financial regulation — what's working, what's not, and what's next

Why It Matters

More than 80 percent of the world's systemically important banks now face at least one mandatory climate disclosure or stress testing requirement, according to the Financial Stability Board (FSB, 2025). Yet a Bank for International Settlements (BIS) review found that fewer than 30 percent of supervised institutions can quantify the transmission channels through which physical and transition risks flow into credit, market, and operational losses (BIS, 2025). This gap between regulatory ambition and institutional readiness defines the current state of climate risk in financial regulation.

Climate change threatens financial stability on two fronts. Physical risks such as floods, wildfires, and extreme heat damage collateral values, disrupt supply chains, and inflate insurance claims. Transition risks emerge as policy shifts, technology changes, and shifting consumer preferences strand carbon-intensive assets. The European Central Bank (ECB) estimated in its 2024 climate stress test that unmitigated physical risks could erode eurozone bank capital ratios by up to 1.6 percentage points by 2030 under a delayed-transition scenario (ECB, 2024). For investors, asset managers, and corporate treasurers, the regulatory landscape is evolving rapidly, and understanding what is working, what is falling short, and where the trajectory is headed is essential to managing portfolios, capital allocation, and strategic planning.

Key Concepts

Climate risk taxonomy. Financial regulators distinguish between physical risk and transition risk. Physical risk encompasses acute events (hurricanes, floods) and chronic shifts (sea-level rise, temperature trends). Transition risk covers policy and legal changes (carbon pricing, litigation), technology disruption (renewable energy displacing fossil fuels), and market or reputational shifts. The Network for Greening the Financial System (NGFS) has developed six reference scenarios that regulators worldwide use to calibrate stress tests, ranging from orderly transitions to disorderly and hot-house world pathways (NGFS, 2024).

Stress testing vs. scenario analysis. Stress testing applies specific shocks to bank balance sheets and measures the capital impact under adverse conditions. Scenario analysis is broader, exploring how climate pathways affect entire portfolios over longer horizons (often 30 years or more). The ECB, Bank of England (BoE), and the Federal Reserve have all conducted exploratory climate scenario exercises, though with varying degrees of rigor and consequence. The ECB's 2024 exercise covered 110 significant institutions, while the Fed's pilot in 2023 included six of the largest US bank holding companies (Federal Reserve, 2023).

Disclosure frameworks. The Task Force on Climate-related Financial Disclosures (TCFD), now consolidated into the International Sustainability Standards Board (ISSB) standards IFRS S1 and S2, provides the backbone for climate reporting. The ISSB standards became effective in January 2025, and as of early 2026, more than 30 jurisdictions have adopted or announced adoption of ISSB-aligned requirements (IFRS Foundation, 2026). The EU's Corporate Sustainability Reporting Directive (CSRD) goes further, requiring double materiality assessments from approximately 50,000 companies starting in 2025.

Prudential expectations. Supervisors increasingly embed climate risk into existing prudential frameworks rather than creating standalone capital requirements. The ECB issued binding supervisory expectations in 2020 and set a series of deadlines for compliance, with full integration into Supervisory Review and Evaluation Processes (SREP) completed in 2024. The BoE's Supervisory Statement SS3/19 similarly requires banks and insurers to embed climate risk into governance, risk management, scenario analysis, and disclosure.

Transition planning. A newer regulatory frontier, transition planning requires financial institutions to articulate how they will align their balance sheets with net-zero targets. The UK Transition Plan Taskforce (TPT) published its final framework in 2023, and the FCA began mandating transition plan disclosures for listed companies and large asset managers in 2025 (FCA, 2025).

What's Working

Supervisory pressure is driving institutional change. The ECB's phased approach to supervisory expectations has delivered measurable results. By the end of 2024, 85 percent of directly supervised banks had established board-level governance for climate risk, up from 40 percent in 2021 (ECB, 2025). BNP Paribas restructured its entire risk management architecture to embed climate variables into credit scoring for commercial real estate and corporate lending. ING Group developed sector-specific transition pathways covering its nine most carbon-intensive lending portfolios, with quantified financed emissions reduction targets verified by the Science Based Targets initiative.

Climate stress testing is improving risk awareness. Although no major regulator has yet imposed capital add-ons solely based on climate stress test results, the exercises have catalysed significant improvements in data infrastructure and modelling capabilities. The BoE's Climate Biennial Exploratory Scenario (CBES), completed in 2022 and updated in 2025, revealed that the UK banking sector could absorb climate losses within existing capital buffers under most scenarios, but flagged acute concentration risks in commercial real estate and agriculture. HSBC used its participation in the CBES to build an internal physical risk scoring system covering 2.3 million counterparty locations globally.

Mandatory disclosure is raising the bar. The shift from voluntary TCFD recommendations to mandatory ISSB and CSRD requirements has increased both the volume and quality of climate-related financial data. CDP reported a 24 percent increase in corporate climate disclosures globally between 2023 and 2025, with the most notable improvements in Scope 3 emissions reporting (CDP, 2025). Asset managers like BlackRock and Amundi now integrate ISSB-aligned metrics into portfolio risk dashboards, enabling more systematic comparison across holdings.

Cross-border coordination is advancing. The NGFS now includes 134 central banks and supervisors, up from 8 founding members in 2017. Its scenario framework has become a de facto global standard, enabling comparability across jurisdictions. The Basel Committee's 2024 principles for effective management of climate-related financial risks provide a common floor for prudential expectations, reducing regulatory fragmentation for internationally active banks.

What Isn't Working

Data quality remains the fundamental bottleneck. Despite regulatory progress, climate data is fragmented, inconsistent, and often unavailable at the granularity regulators and risk managers need. A 2025 survey by the Global Financial Markets Association (GFMA) found that 67 percent of banks cite data availability as the primary obstacle to effective climate risk management (GFMA, 2025). Scope 3 emissions data, which typically represents 70 to 90 percent of a financial institution's financed emissions, relies heavily on estimates and sector averages. Geospatial data for physical risk assessment is improving but remains costly and difficult to integrate with existing credit systems.

Stress test results lack teeth. No G7 regulator has imposed binding capital requirements based on climate stress test outcomes. The exercises remain classified as "exploratory" or "learning," limiting their impact on bank behavior. Critics argue that without capital consequences, climate stress tests amount to sophisticated compliance exercises rather than genuine prudential tools. The Federal Reserve's 2023 pilot explicitly stated it would carry "no capital or supervisory implications," raising questions about whether US regulators will move beyond information gathering (Federal Reserve, 2023).

Disclosure greenwashing persists. The proliferation of reporting frameworks has not eliminated superficial or misleading disclosures. A study by the Swiss Finance Institute (2025) found that firms subject to mandatory climate disclosure requirements reduced reported emissions by 8 percent but achieved only 1 to 2 percent actual emissions reductions, suggesting extensive use of accounting adjustments and scope boundary changes rather than genuine decarbonisation (Duchin et al., 2025). The European Securities and Markets Authority (ESMA) flagged "boilerplate" transition plans with insufficient quantitative targets as a persistent concern across CSRD filings in its first review cycle.

Regulatory fragmentation creates compliance burden. Despite progress on harmonisation, significant divergences remain between the EU, US, UK, and Asian approaches. The CSRD's double materiality approach differs fundamentally from the ISSB's single (financial) materiality lens. The SEC's climate disclosure rule, finalised in March 2024 but immediately challenged in court, remains in legal limbo. Japanese, Singaporean, and Australian requirements each add jurisdiction-specific layers. For global banks operating across 50 or more markets, this patchwork creates substantial compliance costs and operational complexity.

Short-term focus undermines long-horizon risk. Traditional risk management frameworks operate on one-to-five-year horizons, whereas the most severe climate impacts materialise over decades. Regulators struggle to compel institutions to manage risks that exceed typical business planning cycles. Discount rates applied in scenario analysis often render long-term physical risks immaterial, leading to a systematic underestimation of tail risks from tipping points such as ice sheet collapse or Amazon dieback.

Key Players

Established Leaders

• European Central Bank — Most advanced climate supervisory programme globally; completed binding supervisory expectations cycle and two rounds of climate stress testing covering 110+ significant institutions
• Bank of England — Pioneer with its Climate Biennial Exploratory Scenario (CBES); published updated SS3/19 guidance integrating climate into all prudential pillars
• Network for Greening the Financial System (NGFS) — 134-member coalition providing reference scenarios, supervisory guidance, and research that underpins global regulatory approaches
• IFRS Foundation / ISSB — Custodian of IFRS S1 and S2 sustainability disclosure standards adopted or endorsed by 30+ jurisdictions

Emerging Startups

• Cervest — AI-powered climate intelligence platform providing asset-level physical risk scores used by banks and insurers
• Riskthinking.AI — Scenario analysis and climate stress testing platform built for financial institutions; founded by former UN climate data expert
• OS-Climate — Linux Foundation-hosted open-source platform building shared climate risk analytics infrastructure for financial institutions
• Jupiter Intelligence — Delivers hyperlocal physical climate risk analytics for real estate and infrastructure lending portfolios

Key Investors/Funders

• Glasgow Financial Alliance for Net Zero (GFANZ) — Coalition of 675+ financial institutions representing over $130 trillion in assets committed to net-zero transition planning
• Climate Data Steering Committee — Public-private partnership co-chaired by CFTC and Bloomberg advancing climate data standardisation
• Bezos Earth Fund — Major funder of climate risk data infrastructure and ISSB capacity building in emerging markets

Action Checklist

• Conduct a gap analysis against ISSB S2 and applicable local requirements. Map current disclosure capabilities to mandatory metrics, including Scope 3 financed emissions, physical risk exposure by geography, and transition plan milestones.
• Invest in granular climate data infrastructure. Procure or build geospatial physical risk tools at asset level. Establish Scope 3 data pipelines that go beyond sector-average estimates using supplier-specific and activity-based approaches.
• Integrate climate variables into core credit and underwriting processes. Move beyond standalone climate assessments toward embedding climate factors in credit scorecards, collateral valuations, and pricing models.
• Develop quantified transition plans with interim targets. Align with the UK TPT framework or equivalent. Include sector-specific decarbonisation pathways, capital allocation plans, and governance escalation triggers.
• Participate in supervisory climate exercises proactively. Volunteer for pilot programmes and engage constructively with regulators. Use stress test findings to strengthen internal capital adequacy assessments rather than treating them as one-off compliance exercises.
• Build internal climate risk expertise. Hire or train specialists who bridge climate science, financial risk modelling, and regulatory affairs. Establish cross-functional working groups connecting sustainability, risk, and finance teams.

FAQ

How do climate stress tests differ from traditional bank stress tests? Traditional stress tests apply macroeconomic shocks (recessions, interest rate spikes) over two-to-three-year horizons and directly affect capital requirements. Climate stress tests use 30-year-plus scenarios based on NGFS pathways, typically remain exploratory without binding capital consequences, and require novel modelling of physical hazards and transition dynamics that traditional risk models were not designed to capture. Most climate exercises also cover a broader scope of risks, including reputational and litigation exposures.

Will regulators impose climate-specific capital requirements? No G7 regulator has yet imposed standalone climate capital charges, and the Basel Committee's 2024 principles explicitly state that existing Pillar 1 and Pillar 2 frameworks can accommodate climate risks. However, the ECB has started factoring climate risk management quality into SREP scores, which indirectly affect capital guidance. Over the next two to three years, supervisors are likely to move from "exploratory" exercises toward climate-adjusted capital assessments, particularly for portfolios with concentrated physical or transition risk exposures.

What is the difference between ISSB and CSRD requirements? ISSB standards (IFRS S1 and S2) focus on financial materiality, requiring companies to disclose climate information that could reasonably influence investor decisions. The EU's CSRD applies a double materiality lens, requiring disclosure of both how climate change affects the company and how the company's activities affect climate and society. CSRD also mandates more granular reporting on taxonomy alignment, biodiversity impacts, and social factors. Companies operating in both EU and non-EU markets may need to comply with both frameworks, though interoperability guidance published by EFRAG and the ISSB in 2024 has reduced some duplication.

How should smaller financial institutions approach climate risk regulation? Smaller institutions should prioritise proportionate responses. Start with qualitative assessments of physical and transition risk exposures across lending portfolios. Leverage freely available tools such as the NGFS scenario explorer and the Climate Financial Risk Forum guides published by the FCA and PRA. Consider industry utility solutions and shared platforms like OS-Climate rather than building bespoke in-house capabilities. Focus initial quantitative efforts on the most exposed sectors (commercial real estate, agriculture, fossil fuel extraction) rather than attempting portfolio-wide analysis immediately.

How reliable are current climate risk models? Climate risk models are improving but remain subject to significant uncertainty. Physical risk models depend on downscaled climate projections that diverge substantially at regional and asset levels. Transition risk models struggle to capture feedback loops, policy discontinuities, and technological breakthroughs. The NGFS itself cautions that its scenarios are not forecasts and should be used as exploratory tools rather than precise predictions. Financial institutions should run multiple scenarios, apply sensitivity analysis, and treat model outputs as directional indicators rather than point estimates.