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The Challenge of Climate Risk Modelling in Financial Institutions – Overview, Critique and Guidance





Climate change poses significant risks to financial institutions and the global economy. However, the quantification and management of these risks is complex and as a consequence methodologies that are employed by financial institutions are in many cases in- complete and in some cases misleading.

This paper discusses the various general issues with climate risk modelling in financial institutions, including data availability and quality, model uncertainty, and integrating climate risks into risk management frameworks. We highlight the quantitative model risk issues in some commonly used frameworks including the recent ECB modelling framework and publicly available models as well as an overview of useful features of academic models and commercial models.

We discuss frameworks for assessing climate risks and propose necessary and desirable model features to meet the needs of financial stakeholders to assess climate risks. The objective is to build a view of how modelling frameworks can better serve the needs ot stakeholders in an economy, from members of the populace, banks, investors, central banks, and policymakers. Specifically we argue that risk management methodology as typically used in finance needs to evolve to better reflect the real world economy, such as the impacts from physical risks and policy driven climate risks.

Without such a means to causally link these real world risks to financial outcomes such as markets, all stakeholders run the risk of incoherent inference and compromised decision making as well as missing significant risks. As such this article should be read by academic researchers, financial risk modellers and model validators tasked with building or assessing the emerging field of climate risk modelling.