Climate risk and financial regulation: what it is, why it matters, and how to navigate the new landscape

Why It Matters

Climate-related financial losses reached $380 billion globally in 2024, the costliest year on record for weather-driven insurance claims (Swiss Re, 2025). Central banks and financial regulators have responded by embedding climate risk into the supervisory architecture at unprecedented speed. As of early 2026, more than 50 jurisdictions have adopted or proposed mandatory climate-related disclosure requirements aligned with the Task Force on Climate-related Financial Disclosures (TCFD) or its successor standards under the International Sustainability Standards Board (ISSB) (IFRS Foundation, 2025). The European Central Bank has found that 78 percent of significant eurozone banks still have material gaps in their climate risk management practices (ECB, 2025), while the Bank of England's 2025 system-wide exploratory scenario estimated that UK financial institutions face up to £225 billion in potential losses under a disorderly transition pathway. For financial institutions, asset managers, and corporates that depend on capital markets, climate risk is no longer a voluntary reporting exercise. It is a prudential and compliance imperative with direct implications for capital adequacy, credit ratings, and access to finance.

Key Concepts

Physical risk versus transition risk. Climate financial regulation distinguishes between two categories of risk. Physical risk refers to the direct financial impact of climate-related events such as floods, wildfires, hurricanes, and chronic changes like sea-level rise and heat stress. Transition risk captures the financial consequences of the shift to a low-carbon economy, including policy changes (carbon pricing, fossil fuel subsidy removal), technology disruption (stranded assets in oil and gas), market shifts (changing consumer preferences), and litigation (climate-related lawsuits against corporates and directors). The Network for Greening the Financial System (NGFS, 2024) has published six reference scenarios spanning orderly transition, disorderly transition, and hot-house world pathways that regulators worldwide use as a common analytical framework.

TCFD framework. The TCFD, established by the Financial Stability Board in 2015, created the foundational four-pillar disclosure framework: Governance, Strategy, Risk Management, and Metrics & Targets. Although the TCFD formally dissolved in October 2023, its recommendations live on through the ISSB standards (IFRS S1 and S2) and through direct regulatory adoption. Over 4,000 organizations across 100 countries had endorsed the TCFD recommendations by the time of its dissolution (TCFD, 2023). The UK, Japan, New Zealand, Switzerland, Singapore, and Brazil have all made TCFD-aligned disclosures mandatory for large companies and financial institutions.

ISSB standards (IFRS S1 and S2). The ISSB released its inaugural standards in June 2023. IFRS S1 sets out general requirements for sustainability-related financial disclosures, while IFRS S2 focuses specifically on climate-related disclosures. By early 2026, more than 30 jurisdictions have committed to adopting or building upon the ISSB standards, including the UK, Australia, Canada, Japan, Nigeria, and Singapore (IFRS Foundation, 2025). The standards require entity-specific, decision-useful disclosures about climate risks and opportunities, including scenario analysis, Scope 1, 2, and 3 greenhouse gas emissions, and transition plans. Importantly, the ISSB standards are designed for capital market decision-making, not for measuring environmental impact per se.

EU regulatory suite. The European Union operates its own comprehensive framework. The Corporate Sustainability Reporting Directive (CSRD), effective from fiscal year 2024, requires nearly 50,000 companies to report under European Sustainability Reporting Standards (ESRS), which include detailed climate risk disclosures under a double materiality lens. The EU Taxonomy Regulation classifies economic activities as environmentally sustainable, creating a common language for green investment. The Sustainable Finance Disclosure Regulation (SFDR) imposes transparency requirements on asset managers regarding sustainability risks in investment products. Together, these form the most extensive climate-finance regulatory architecture globally.

Central bank climate stress testing. Central banks and supervisors are increasingly using climate stress tests to assess the resilience of financial institutions to both physical and transition risks. The ECB conducted its first supervisory climate stress test in 2022 and updated it in 2025, covering 109 significant institutions. The Bank of England ran its second Climate Biennial Exploratory Scenario (CBES) in 2025. The Federal Reserve completed its pilot climate scenario analysis with six large US banks in 2024 (Federal Reserve, 2024). These exercises are not yet binding in the way traditional capital stress tests are, but they signal the direction of travel: regulators are building toward integrating climate scenarios into Pillar 2 capital requirements.

Prudential expectations. Beyond disclosure, supervisors are setting expectations for how banks and insurers integrate climate risk into their core risk management frameworks. The ECB published its Guide on Climate-Related and Environmental Risks in 2020 and has since conducted multiple supervisory reviews, issuing binding remediation actions to institutions that fail to meet expectations. The Bank of England's SS3/19 supervisory statement requires PRA-regulated firms to embed climate risk across governance, risk appetite, scenario analysis, and disclosure. The Basel Committee on Banking Supervision issued principles for climate risk management in 2024, providing a global baseline that national regulators are expected to implement.

How It Works

Disclosure and reporting. Financial institutions begin by identifying and disclosing their exposure to climate-related risks and opportunities. Under ISSB or CSRD requirements, this means publishing annual disclosures covering governance arrangements for climate risk oversight, the organization's strategy under different climate scenarios, how climate risks are identified and managed within the broader risk management framework, and quantitative metrics including Scope 1, 2, and 3 emissions, climate-related targets, and transition plan milestones. Large banks and insurers typically use specialized data platforms such as those offered by MSCI, S&P Global Trucost, or Moody's to aggregate emissions data across loan portfolios and investment holdings.

Scenario analysis and stress testing. Regulators require or strongly encourage financial institutions to conduct forward-looking scenario analysis. Institutions select NGFS-aligned scenarios (typically a 1.5°C orderly transition, a delayed/disorderly transition, and a 3°C+ hot-house scenario) and model the financial impact on their portfolios. For banks, this means estimating how transition and physical risks affect credit risk (probability of default, loss given default), market risk (asset repricing), and operational risk. For insurers, the focus is on how changing hazard frequencies and severities affect claims and reserves. The ECB's 2025 stress test required banks to model the impact of a sudden carbon price rise to EUR 300 per tonne on their corporate loan books, revealing that institutions with high exposure to carbon-intensive sectors could face credit losses 2 to 3 times higher than those with diversified portfolios.

Risk integration and capital implications. Leading institutions are moving beyond disclosure and scenario analysis to embed climate risk into day-to-day risk management. This includes adjusting internal credit ratings to reflect borrowers' transition exposure, incorporating physical risk scores into property lending valuations, setting sector-level concentration limits for high-carbon exposures, developing climate-adjusted economic capital models, and pricing climate risk into loan origination and insurance underwriting. The Basel Committee's 2024 principles explicitly state that climate risk should be integrated into existing risk categories (credit, market, operational, liquidity) rather than treated as a standalone category. Some regulators, notably the ECB, have begun imposing Pillar 2 capital add-ons for institutions with inadequate climate risk management, making capital a direct lever for enforcement.

Transition planning. The UK's Transition Plan Taskforce (TPT) published its gold-standard disclosure framework in October 2023, and the FCA has proposed making TPT-aligned transition plan disclosures mandatory for listed companies and regulated financial firms by 2027 (FCA, 2025). Transition plans require institutions to articulate credible, time-bound strategies for aligning their business models with net-zero commitments, including interim targets, capital expenditure plans, and governance mechanisms for accountability.

Key Players

Established Leaders

• IFRS Foundation / ISSB — Global standard-setter for climate-related financial disclosures. IFRS S1 and S2 adopted or endorsed by 30+ jurisdictions.
• European Central Bank (ECB) — Conducted the largest supervisory climate stress test in 2025 covering 109 significant eurozone banks, and issues binding remediation actions for inadequate climate risk management.
• Bank of England / PRA — Issued SS3/19 supervisory expectations and completed two Climate Biennial Exploratory Scenarios, with plans to integrate climate into core stress-testing by 2028.
• Network for Greening the Financial System (NGFS) — Coalition of 134 central banks and supervisors that publishes the reference climate scenarios used globally for financial risk assessment.

Emerging Startups

• Risilience — Enterprise climate risk analytics platform that translates physical and transition scenarios into financial impact metrics for boards and CFOs.
• Cervest — Provides asset-level physical climate risk intelligence using satellite data and machine learning, serving banks, insurers, and real estate investors.
• OS-Climate — Open-source initiative (hosted by the Linux Foundation) building an integrated data and analytics platform for climate-aligned finance.
• Planetrics (acquired by McKinsey) — Climate scenario analysis and portfolio alignment tool used by asset managers to quantify transition risk at the security level.

Key Investors/Funders

• Glasgow Financial Alliance for Net Zero (GFANZ) — Umbrella coalition representing over $130 trillion in assets committed to net-zero alignment, providing sector-specific transition finance guidance.
• UN Principles for Responsible Investment (PRI) — Over 5,300 signatories representing $121 trillion in AUM; provides implementation guidance on integrating climate risk into investment decision-making.
• Climate Finance Leadership Initiative (CFLI) — Convened by Michael Bloomberg, mobilizes private capital for climate solutions in emerging markets through blended finance structures.

Action Checklist

• Map your regulatory exposure. Identify which climate disclosure and risk management requirements apply across all jurisdictions where you operate. Create a regulatory horizon scanner covering ISSB adoption timelines, CSRD phase-in schedules, and national supervisory expectations.
• Establish governance structures. Ensure board-level oversight of climate risk with clear accountability. Appoint a Chief Sustainability Officer or equivalent with a direct reporting line to the CEO and board risk committee.
• Build data infrastructure. Invest in granular emissions data collection across Scopes 1, 2, and 3 for lending and investment portfolios. Evaluate vendor platforms (MSCI, S&P Trucost, Moody's) for portfolio-level analytics and integrate climate data into existing risk systems.
• Conduct scenario analysis. Run NGFS-aligned scenario analyses covering orderly, disorderly, and hot-house pathways. Translate outputs into credit risk, market risk, and underwriting impact estimates. Repeat annually and refine as methodologies improve.
• Develop a transition plan. Align with the UK TPT framework or equivalent standard. Set interim and long-term decarbonization targets for financed emissions, identify capital allocation shifts needed, and establish governance mechanisms for tracking progress.
• Integrate into risk management. Embed climate risk factors into credit origination, portfolio monitoring, insurance underwriting, and investment due diligence processes. Adjust internal rating models and risk appetite statements to reflect climate exposure.
• Train and upskill. Climate risk analysis requires a blend of financial, scientific, and regulatory expertise. Invest in cross-functional training for risk managers, credit analysts, portfolio managers, and board members.
• Engage with regulators and peers. Participate in industry consultations, supervisory pilot programs, and pre-competitive data sharing initiatives. Early and constructive engagement helps shape workable regulation and builds supervisory goodwill.

FAQ

What is the difference between TCFD and ISSB? The TCFD created the foundational four-pillar disclosure framework (Governance, Strategy, Risk Management, Metrics & Targets) in 2017. When the TCFD formally dissolved in October 2023, the IFRS Foundation's ISSB assumed responsibility for monitoring progress on climate-related disclosures. IFRS S2 incorporates and builds upon all TCFD recommendations, adding more detailed requirements around scenario analysis, Scope 3 emissions, and transition plans. In practice, organizations already aligned with TCFD will find the transition to ISSB standards incremental rather than transformative, but the additional granularity and jurisdictional adoption timelines require careful planning.

Are climate stress tests legally binding? As of early 2026, most climate stress tests remain exploratory rather than binding in the way traditional capital adequacy stress tests are. However, regulators are using the results to inform supervisory assessments. The ECB has imposed Pillar 2 capital add-ons on institutions with material climate risk management deficiencies, and the Bank of England has indicated it will integrate climate scenarios into its standard Annual Cyclical Scenario by 2028. The direction is clearly toward binding integration; institutions should treat current exercises as preparation for more consequential future requirements.

How should smaller financial institutions approach climate regulation? Smaller institutions face proportionality provisions in most regulatory frameworks. CSRD applies initially to large and listed companies, with SME requirements phased in from 2028. The ISSB standards are designed for capital market participants, and most jurisdictions adopting them apply them to listed entities above certain thresholds. However, smaller banks and asset managers are increasingly affected through value chain requirements: large corporate borrowers subject to CSRD will demand climate data from their banking partners, and institutional investors with PRI commitments will require climate disclosures from fund managers of all sizes. Starting with a materiality assessment, basic Scope 1 and 2 emissions measurement, and qualitative scenario analysis is a pragmatic first step.

What data challenges should we anticipate? The most persistent challenge is Scope 3 and financed emissions data quality. For banks, estimating the carbon footprint of a diversified loan portfolio requires emissions data from thousands of borrowers, many of whom do not yet report. Industry averages and spend-based estimates fill the gaps but introduce significant uncertainty. Physical risk data is improving rapidly thanks to satellite observation and geospatial analytics, but asset-level granularity remains inconsistent. Institutions should invest in data governance frameworks, establish clear methodological documentation, and use scenario ranges rather than point estimates to communicate uncertainty transparently.

How does climate regulation interact with traditional financial regulation? Climate risk is not a new risk category but rather a driver of existing financial risks. Credit risk increases when borrowers face transition costs or physical damage. Market risk rises when asset prices reprice to reflect carbon constraints. Operational risk grows as extreme weather disrupts business continuity. Liquidity risk can materialize if climate events trigger sudden deposit outflows or margin calls. Regulators expect institutions to integrate climate considerations into these existing risk frameworks rather than building parallel systems. The Basel Committee's 2024 principles reinforce this integration approach and provide the global baseline that national supervisors are implementing.