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Climate risks for the financial sector

Financial institutions, through their investments in companies, are exposed to physical risks (the impact of natural disasters) and transition risks (e.g. losses due to the declining value of investments in carbon-intensive companies). To provide insight into these risks, DNB, together with the ECB and other euro area central banks, has developed several sustainability indicators. 

What are the limitations of these statistics?

Because sustainability figures are so urgently needed, we have decided to make them available as soon as possible to anyone who wishes to use them. They are not yet complete and their quality is not yet comparable to that of our regular statistics.

Some of the published figures do not yet cover the full portfolios of financial institutions in some cases. This means that in most cases they can be interpreted as a lower limit of the actual transition and financial risks.

Further examples of data limitations include the fact that, in the indicators for physical risks, we have not been able to include all the locations of companies in which the financial sector invests, but only head office locations.

Accordingly, we wish to stress that this data must be treated with circumspection, especially when drawing conclusions or formulating policies.

The scope of the indicators covers investments in and loans to non-financial corporations by financial institutions (the assets). This dashboard does not cover mortgage loans and other consumer loans.

Physical risks

More extreme weather conditions are likely to make natural disasters more frequent. Besides their impact on society, natural disasters also cause damage to the economy. The physical risk indicators show the impact of natural disasters on the investments of Dutch financial institutions (banks, insurers, investment funds and pension funds) in non-financial corporations. Three indicators have been developed to show this impact:

  • The PEAR (Potential Exposure At Risk)
  • The NEAR (Normalised Exposure At Risk)
  • The CEAR (Collateralised Exposure At Risk)

These indicators calculate the impact of different types of natural disasters: coastal floods, consecutive dry days, landslides, river floods, standardised precipitation index, subsidence, water stress, wildfires and windstorms.

They reflect historical conditions or future climate scenarios, called representative concentration pathways (RCPs). Two RCPs are calculated:

  • RCP 4.5: this is a moderate scenario, which assumes policy action aimed at reducing greenhouse gas emissions, without taking any drastic action.
  • RCP 8.5: this is the worst-case scenario in which emissions are not reduced during the 21st century, but instead continue to increase.

PEAR indicator

The PEAR indicator looks at bonds and shares issued by, and loans provided to, non-financial corporations in the euro area. Financial institutions that hold bonds and shares are called 'holders', and financial institutions that provide loans are called 'creditors'.

The PEAR indicator provides insight into the total volume of assets of Dutch financial institutions exposed to a given natural disaster. All risks are weighted equally regardless of the disaster’s probability.

The PEAR indicator can be supplemented by risk scores, which indicate how likely the natural disaster is to occur, from low risk to high risk.

Example: The high risk indicator for water stress is 13.5%. This means that 13.5% of the total portfolio value of Dutch financial institutions is located in areas at high risk of water stress.

NEAR indicator

The NEAR indicator shows the risk banks face through the loans they provide to non-financial companies. The NEAR indicator considers both the intensity and the probability of a natural disaster. It also takes into account the disaster’s impact. The NEAR indicator is only available for coastal and river floods and windstorms.

Example: For a flood with a water depth of 1 metre, damage to a company's premises and equipment is assumed to be 25%, while for a water depth of 3 metres, the assets are considered lost.

The NEAR indicator assumes that if a company loses 10% of its assets due to a flood, 10% of the outstanding loan amount cannot be repaid. This creates a measure of the expected loss for the bank.

There are two versions of the NEAR indicator:

  • NEAR annual: this shows the expected loss for one year.
  • NEAR maturity: this shows the expected loss over the maturity of the loans in the portfolio.

Example: The value of 'NEAR annual' due to windstorms is €58 million. This means that the expected annual loss on loans to non-financial corporations in the euro area due to windstorms for Dutch banks is €58 million.

CEAR indicator

The CEAR indicator is based on the NEAR indicator, but additionally takes into account financial and physical collateral. This collateral is linked to the loan and the bank can seize it if the company can no longer repay the loan. The loss from a natural disaster remains the same for the company, but the existence of collateral reduces the bank’s expected loss. It takes into account the expected decrease in the value of the physical collateral caused by the natural disaster. Like the NEAR indicator, the CEAR indicator has two versions: annual and maturity.

Example: The value of 'NEAR annual' due to river floods is €5 million, and the value of 'CEAR annual' due to windstorms is €3 million. This means that €2 million of the expected loss is covered by collateral.

Carbon footprints of pension funds, insurers and investment funds (WACI)

The transition to a climate-neutral economy by 2050 may reduce the value of assets in carbon-intensive industries. This is why it is important to quantify the emissions that financial institutions finance through their investments. To do so, the Weighted Average Carbon Intensity (WACI) is used.

WACI shows the relative carbon emission per million euro of company revenue (carbon intensity), weighted by the investor's portfolio weight. This indicator is relative in two ways:

  1. Carbon intensity reflects an issuer's emissions relative to its revenue.
  2. Portfolio weight indicates the value of an investment relative to the investor's entire investment portfolio.

While this indicator allows for comparing the carbon intensities of sectors or individual financial institutions, it does not provide information on the absolute level of emissions.

The charts below show the WACI time series on the left axis, and the change in WACI over the years on the right axis, both for pension funds/insurers and for investment funds. 2020 and 2021 are corona years. The decrease in WACI during this period can be partially attributed to an increase in revenue, due to economic recovery.

The change in WACI is decomposed into changes due to three effects: carbon emissions, revenue and capital reallocation (e.g. investments and disposals in an investment portfolio).

Topics sustainability