Climate risk modelling

 

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CLIMATE RISK MODELLING: A FINANCIAL PERSPECTIVE IN 2025

 

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Estimated reading time: 4 min.

 

 

Climate risk has become a defining theme in financial regulation and portfolio management. For asset managers, insurers and banks, it is no longer a side issue: supervisors now demand concrete evidence of how climate-related risks impact portfolios, capital and long-term strategies.


The distinction between physical risks and transition risks structures the debate. Physical risks cover acute events (storms, floods, wildfires) and chronic trends (sea-level rise, droughts, heatwaves). Transition risks arise from policy changes, carbon pricing, litigation, or disruptive technologies. Standards like IFRS S2 now require disclosure of exposures to both categories and scenario analysis across multiple horizons.

From a modelling perspective, logic follows the chain hazard → exposure → vulnerability → loss. Hazards are mapped using scientific datasets such as the IPCC AR6 Interactive Atlas, Copernicus EFAS for floods or EFFIS for wildfires. Exposure data come from asset geolocation and sectoral breakdowns, while vulnerability is captured by damage functions that translate hazard intensity into expected losses. The NGFS Phase V scenarios (2024) updated these functions, leading to higher projected economic impacts. In 2025, the NGFS went further with short-term climate scenarios, focusing on a five-year horizon to bridge the gap between long-term transition pathways and supervisory stress tests.

 

WHAT ABOUT EUROPE ?

 

At the European level, the European Climate Risk Assessment (EUCRA, 2024) identified 36 priority risks across ecosystems, health, food, infrastructure and finance. This taxonomy helps financial institutions structure their materiality assessments and risk appetite frameworks. Complementary tools such as the WRI Aqueduct Atlas (water stress and flood risk indicators) or the CRREM pathways (real estate decarbonisation benchmarks and “stranding years”) provide actionable metrics for investors.


Supervisors are accelerating expectations. The EBA Guidelines on ESG risks (2025) require banks to integrate climate risk drivers into ICAAP and transition plans. EIOPA’s ORSA guidance compels insurers to test resilience under climate scenarios over at least 10 years. The ECB climate stress tests highlight both the materiality of risks and the data/methodological gaps that institutions must close.


For practitioners, the frontier lies in hybrid modelling: combining bottom-up catastrophe models for physical perils with top-down macro scenarios (NGFS, IEA) for transition shocks. This dual approach allows financial institutions to translate climate change from a broad sustainability narrative into quantifiable inputs for pricing, capital allocation, solvency, and strategic planning.

 

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COMMON QUESTIONS ABOUT THIS TOPIC


It is the process of using quantitative and qualitative methods to assess how physical and transition climate risks (e.g., extreme weather, regulatory shifts, carbon pricing) may impact portfolios and assets over multiple future scenarios.


Because it enables identifying vulnerabilities, quantifying potential losses or shifts in value, aligning with regulatory frameworks (e.g., ESG disclosures) and enabling resilience-oriented decisions before stranded assets or risk shocks occur.


Key components include: scenario analysis (future climate/transition pathways), exposure and vulnerability assessment (which assets are at risk), impact quantification (how much value could be affected), and uncertainty management (what-ifs and tail risks).


Limitations include data gaps (especially regional/local), model uncertainty (scenario assumptions), non-linear risks and tipping points, and the challenge of translating climate model output into financial/business metrics.


It informs governance by providing structured risk-insights, supports disclosures (e.g., aligned with Task Force on Climate‑related Financial Disclosures frameworks), and enables integration of climate risk into strategic allocation, monitoring and stewardship processes.