Pim Poppe & Kamuran Emre Erkan: Climate and nature risks are interlinked and mutually reinforcing
Pim Poppe & Kamuran Emre Erkan: Climate and nature risks are interlinked and mutually reinforcing
By Pim Poppe, Managing Partner at Probability & Partners, based on the subject-matter expertise of Kamuran Emre Erkan, Quantitative Consultant at Probability & Partners
Over the last two years we have been building climate risk models and integrating them into credit risk management for various clients. One of the most interesting findings was that, for some portfolios, physical risk is more significant, while for others, transition risk takes precedence. We are now broadening our horizons by incorporating nature risk into our work. An integrated approach to climate and nature risks is essential.
Our models have been instrumental in helping our clients tackle the complexities of climate-related financial risks, including both physical and transition risks. In addition to developing these models, we have also validated them for other banking clients, ensuring their robustness and effectiveness in real-world applications.
One of the most interesting findings was that, for some portfolios, physical risk is more significant, while for others, transition risk takes precedence. The main driver of transition risk is the carbon intensity of the portfolio, which plays a critical role in determining exposure, while for physical risk the severity of the extreme weather events relevant for the loans in the portfolio is significant.
From climate to nature risk
Starting at the end of 2024, we are shifting our focus and broadening our horizons by incorporating nature risk into our work. Together with our clients, we are exploring how to identify, model, and measure the financial risks arising from biodiversity loss and ecosystem degradation. Measuring nature risk is uncharted territory for many, but it offers significant opportunities to better understand and address the interconnected risks that nature and climate pose to businesses and the financial system.
The importance of nature risk
Nature risk encompasses financial risks arising from biodiversity loss and the degradation of natural assets. These risks stem from both dependency on natural sources such as water, timber and fisheries, as well as the adverse effects of ecosystem degradation, including soil erosion and water scarcity. Additionally, transition risks emerge from shifts in policies, markets and reputational factors, further impacting the financial stability.
Although banks have made strides in assessing climate risk, nature risk remains relatively underexplored. The two types of risk are distinct but closely linked. Climate risk often focuses on extreme weather events and physical damages, while nature risk arises from dependencies on ecosystems and the degradation of natural assets. An integrated approach is essential, as climate and nature risks are interlinked and mutually reinforcing. Therefore, addressing them in isolation could result in their underestimation.
Nature risk is not just an ethical issue; it is a core economic and financial concern. Our economies are fundamentally dependent on ecosystem services and natural assets. Ecosystems provide clean water, fertile soil, pollination, climate regulation, and countless other benefits that underpin global economic stability. The degradation of these ecosystems presents material financial risks that no institution can afford to ignore.
Regulation
Adding to the urgency, regulators are stepping in. The European Central Bank has made it clear that 2025 is a key year for banks to incorporate nature risk assessments into their risk management frameworks. Moreover, the upcoming Capital Requirements Regulation (CRR3) and Capital Requirements Directive (CRD6) explicitly require banks to assess environmental damage and biodiversity loss. This regulatory push signals that managing nature risk is not optional—it is essential.
For insurers, the situation is comparable to that of banks. The European Insurance and Occupational Pensions Authority (EIOPA) has recently recommended updates to the standard formula calibrations for natural catastrophe risks, including flood, hail, earthquake, and windstorm for certain regions. These new risk factors are set to be implemented in 2025. EIOPA is also conducting analysis on biodiversity loss risk in the insurance industry. They are collecting evidence on industry practices for identifying and managing biodiversity loss risk, focusing on the Own Risk and Solvency Assessment (ORSA). EIOPA plans to deliver a report to the European Commission on its findings by June 2025.
Globally, the Taskforce on Nature-related Financial Disclosures (TNFD) has released its final recommendations, providing a framework for organisations to report and act on evolving nature-related risks. These developments indicate a clear trend towards more comprehensive and standardised nature-related reporting and risk management.
Conducting nature risk assessments
Conducting nature risk assessments is a complex but critical task. Banks and Insurers should adopt a standardised, high-level approach initially, avoiding excessive granularity across different natural assets or sectors. Mechanisms such as the ENCORE tool can help identify dependencies and impacts of financial activities on natural capital. Public data providers like the Global Biodiversity Information Facility and UNEP-WCMC also offer valuable biodiversity and ecosystem data.
To get started, banks should begin by understanding their loan book’s dependencies and impact on natural resources, conducting pilot assessments using available tools, and fostering interdisciplinary collaboration among ecologists, economists, and risk managers. An iterative approach is recommended, allowing for gradual refinement of models and assessments while starting conservatively with nature impacts.
Managing nature risk is a new domain for most financial institutions, requiring interdisciplinary collaboration, innovation, and significant effort. The work will evolve as institutions strive to find the right balance of granularity in their assessments. It is crucial to start with a balanced top-down and bottom-up approach, recognising the inherent uncertainties about how nature degradation has a potential impact on loan books or insured portfolios.
Get started
Financial institutions must act soon to understand and manage nature-related risks effectively. By taking action now, they can position themselves as leaders in this emerging field and contribute to a more sustainable future. Additionally, they can improve the long-term risk-return profile of their asset and insurance portfolios. Starting in 2025, the integration of nature risk into financial risk management will become not just a regulatory requirement but a fundamental aspect of responsible and forward-thinking business practice.