19 October 2022

Mariken van Loopik, Tjalling Waterbolk and Thom Wetzer on scenario-driven climate risk management for banks and insurers

Climate risk management is increasingly salient for boards of banks and insurers. Although the expectation that risks should be assessed and managed is uncontroversial, climate risk has unique properties that substantially complicate these processes. In this article, we outline key challenges for boards when discharging their responsibilities given the uncertainty around the manifestation of climate risks.

Risk modelling in the financial sector is predominantly based on historical data that are extrapolated to the future. The premise underpinning such models, that the future looks like the past, does not hold in the face of a changing climate. Climate risks must therefore be 'quantified' by means of scenarios, which correspond to transition pathways. The selection and specification of these scenarios thus forms the basis of the climate risk management framework and boards' business and strategic decisions. The reliability of these assessments and the adequacy of management actions based on them is highly contingent on the materialisation of a specific scenario.