Climate risk does not affect systemic financial risk

February 22, 2025

Climate risk is not a systemic financial risk. Folding it into financial regulations will likely backfire, not mitigate climate damage and even increase systemic risk.

Achieving carbon neutrality is a top priority, and a real challenge lies in how to go about it. Many propose using financial regulations as a tool, but is that the right approach? It depends on if climate risk is systemic.

It's often claimed that climate risk threatens financial stability, hence leading calls for regulators to treat it like any other systemic threat. But does that claim really hold up?

Not according to the standard definition of systemic risk set by global authorities after the 2008 crisis. It defines systemic financial risk as the likelihood of a financial crisis that may severely disrupt the real economy. That means losses reaching trillions in the world's largest economies.

While climate damage could certainly rack up costs on that scale, it doesn't automatically make climate risk systemic. There's more to it than just the price tag.

Systemic financial risk mainly stems from banks, not insurers or asset managers. Any disruption to bank operations has real consequences because banks provide the critical services that keep the real economy going — hence the bailouts and heavy regulations. That applies to neither insurance nor asset management. Their losses are born by private investors but do not overly disrupt the real economy — unless, of course, they trigger a banking crisis.

If climate risk is to have systemic consequences, it has to flow through the banking system.

Many researchers argue that since banks have made significant loans to "brown" sectors — vulnerable to major climate-related losses — this justifies imposing systemic charges on such lending.

This argument is specious.

Consider both the short- and long-term consequences of the climate for the financial system. 

In the short term, climate volatility affects risks in lending in vulnerable areas — think hurricanes, floods and droughts. However, these risks appear to be already priced, especially by insurers who openly account for them. As a result, short-run climate risks are unlikely to pose a systemic threat to the banking sector. It is almost axiomatic that systemic threats emerge where nobody is looking.

The biggest costs and uncertainties come in the long run — think rising sea levels over decades or centuries. But this long timeline gives banks plenty of time to adjust and offload risk. Most bank loans mature well before these impacts hit, and as the timeline shortens and risks become clearer, banks will naturally adapt and reprice risk.

Therefore, long-term climate risks are unlikely to pose a systemic threat to the banking sector.

There's an important caveat: if major climate threats hit all at once, banks might not have time to exit, a dynamic that has triggered past banking crises with systemic fallout. But climate shocks don't typically strike with the sudden, rapid impact — over days or weeks — that characterises traditional financial crises, making such a scenario unlikely.

How not to model the climate-systemic nexus

It's easy to see the theoretical links between climate and the financial system — but putting that into practice is far more complex.

Even basic data on the scale of the problem is lacking. Classifying firms as "brown," "green" or "neutral" is tricky since many operate across multiple sectors. Plus, privately held companies often reveal little about their climate impact, adding to the uncertainty.

Despite the surge in climate data and ESG ratings, much of it is biased and often misleading. Companies can easily game the system — greenwashing their image without real change. This is almost inevitable, as ratings are designed to influence behaviour, triggering reactions according to Goodhart's law.

Some researchers suggest instead using market risk tools like 99% daily Value-at-Risk, Expected Shortfall, or credit measures like CDS spreads to assess climate-related risks.

The issue is that such metrics do not reflect systemic or climate risk. They're built to capture minor events that occur every few months — hardly the scale or timeline of systemic crises. Made for managing trading portfolios — hence the name market risk  — not long-term, large-scale risks like climate change. I explored this in more detail in my post, Why the risk you measure is probably not the risk you care about.

An approach to modelling

The gap between investment decisions and their climate outcomes spans decades, even centuries. That is why the financial and political benefit of doing nothing today often trumps mitigating future disasters.

A sensible analytic framework for the climate-finance nexus should consider a multidimensional stochastic model that accounts for:

1. The lead-lag time between actions and outcomes is measured in decades, i.e. the maturity mismatch between investors and lenders vs. climate damage;
2. The distribution of system outcomes has low volatility but fat tails;
3. Growing uncertainties over longer time horizons;
4. The need for significant public and private investment;
5. Political reluctance to shoulder the required financial burdens.

What to avoid in leveraging finance to mitigate climate risk? 

Imagine the authorities push policies that steer bank lending and private investment away from brown sectors and toward green initiatives.

Brown investments will remain profitable — even more so. Limiting investment in sectors like mining could drive up company profits and mineral prices, making these assets even more valuable.

Mining firms could go private or be sold to offshore entities (or relist) beyond the reach of domestic regulations, reducing oversight of brown activities and leaving us worse off.

Pushing for climate-friendly energy production can drive up energy costs, shifting high-energy manufacturing to countries without such restrictions.

These policies have clear distributional impacts: current firm owners may lose out while rising costs fuel inflation.

So, it represents a net transfer from pension funds, insurance companies, university endowments, and other domestic investors — as well as the poorest part of the population — to investors willing to hold mining assets, often based overseas, all without actually reducing brown activities. 

A financial regulatory policy that encourages green investments inevitably results in lower returns for the affected investors. Pension funds and insurance companies will then face the challenge of balancing reduced returns with client expectations and legal obligations.

Why are we making those entities pay the cost and not other parts of the economy?

Of politics and populism 

Proposals to use the European Central Bank and its banking regulations to drive green policies — currently under discussion in Europe — risk politicising central banks further, exposing them to greater criticism. This could undermine their core responsibilities: monetary policy and financial stability.

And that alone is a strong reason to keep financial regulations out of climate risk mitigation.

But there's another reason: populism. As I'll explore in an upcoming post, populism is a major driver of systemic risk.

We've already seen climate policies disproportionately impact poorer citizens and regions, sparking movements like the Farmer Citizen Movement in the Netherlands, the Gilets Jaunes in France, and opposition to ULEZ in the UK.

The British government's recent retreat from climate initiatives, seems to be driven by fear of political backlash, combined with a push for economic growth. The CDU in Germany in the recent election attacked green policies. Similar dynamics are playing out in the United States and other countries.

Focusing only on financial regulations as a driver of green investments without accounting for the political fallout is, at best, naïve — and at worst, counterproductive. Achieving meaningful carbon reduction requires a clear democratic mandate.

If such policies inflame populism, they also fuel systemic financial risk and are, hence, counterproductive. 

So

Cutting carbon emissions and limiting climate damage are top priorities. While using capital charges might seem like an easy solution, it's unfair, regressive, and ultimately ineffective. There are better policy tools.

Current proposals to use bank regulations to cut carbon emissions ignore political realities. They risk misallocating scarce resources, empowering climate deniers, and, worse, aligning poorer voters with anti-climate agendas — fuelling populism. In the end, this approach undermines the core mission of central banks: safeguarding monetary and financial stability.

I thank Robert MacRae for valuable comments

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