How Will Lenders Factor Climate Risks into Underwriting?

By Tony Liou, Partner Energy President & Kathryn Peacock, Principal and National Client Manager for Partner Engineering and Science, Inc

Fed says climate change can result in direct financial risks and bank stress testing is likely coming. Lenders can start managing those risks now.

Lenders and investors are beginning to identify climate change impact as an emerging risk that has the potential to profoundly impact not only their physical assets, but also entire financial systems due to climate change related events. Climate change can result in “direct financial risks, prompting a reassessment of asset values, changing the cost or availability of credit, or affecting the timing or reliability of cash flows,” as noted in “Climate Change and Financial Stability”, published by the Federal Reserve Board of Governors in March 2021. And just today, Chairman Jerome Powell suggested that the Fed will probably require banks to conduct stress testing for climate vulnerability at some point in the future.

Physical risks–manifestations of a changing climate and the associated costs–are top of mind for most financial institutions, as they could directly impact asset value and borrower solvency. Physical risks are varied and include chronic risks like extreme heat, drought, and water access as well as acute risks like wildfires, hurricanes, and flooding. Due to increasing frequency and severity of acute events, it is therefore vital for lenders to begin to understand how climate change may impact properties and approach risk management systemically. Lenders are grappling with how to address this. Few lenders want to be out front making tough decisions based on climate risks, so for now, they can at least begin to collect data about their assets to start understanding future risks. Even if climate risks are not factoring into financial decisions, understanding the risks now will have long-term benefits.

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