Managing environmental hazards within the financial sector

The financial sector is increasingly acknowledging the significance of climate-related risks, especially those linked to nature, as the global economy transitions towards sustainable finance opportunities. This shift in awareness forms a key theme in the latest edition of OMFIF's Sustainable Policy Institute Journal.

Sem Housen and Emily Dahl from the United Nations Environment Programme Finance Initiative argue that the financial sector should turn away from nature-negative flows and towards activities that mitigate climate change and build resilience. They emphasize the importance of biodiversity in capital markets, with Marcus Pratsch from DZ BANK echoing this sentiment, stating that nature-positive solutions must remain central to the net-zero transition.

Financial institutions have made substantial progress in integrating climate risk into their stress testing frameworks. As of 2025, all banks have included climate risk in such frameworks, a marked improvement from 41% in 2022. However, many institutions have yet to cover all material climate and nature risk drivers comprehensively, according to William Attwell at Sustainable Fitch.

Accurately determining climate impacts remains challenging. Financial firms face difficulties in integrating the medium- and long-term manifestations of climate risk within traditional risk management frameworks. Scenario modelling is a key tool but requires improvement to capture all material risk drivers, including transmission channels and nature-related risks.

A critical constraint identified is the mismatch between how climate finance is structured and how climate action is pursued, especially in developing countries. This misalignment limits the effectiveness of capital flows for climate finance, emphasizing a need for recalibration of sustainability regulations and financing mechanisms.

Declines in ecosystem services are now recognized as a material source of financial risk. However, many banks do not yet fully integrate nature-related risks into their internal capital adequacy assessments or stress testing, despite their growing significance amid global heating trends.

European Central Bank leadership highlights that climate shocks, both physical (e.g., extreme weather) and transition-related, when combined with financial vulnerabilities, could unleash severe financial losses. Central banks and public investors are actively exploring these risks to shape supervisory practices and encourage financial institutions to better prepare for climate-related financial shocks.

On the macroeconomic front, public finances are expected to be strained by climate change through increased government debt due to both transition costs and damage from a warmer, wetter climate. This adds layers of complexity to fiscal sustainability beyond traditional economic shocks, putting pressure on central banks and governments to manage these evolving risks.

To address these challenges, financial regulators, including central banks, are urging institutions to implement more comprehensive climate and nature risk stress testing and integrate these risks into capital planning processes. Dialogue and engagement between regulators and financial institutions continue, focusing on best practices and overcoming challenges such as financed emissions rising temporarily during client transitions to net zero.

There is a clear push for improving data quality, scenario modelling, and the regulatory environment to better align loan and investment portfolios with climate objectives while managing transition risks effectively. Subscribing to OMFIF's newsletter provides more information on this topic.

In summary, while the financial sector has made notable strides in recognizing and managing climate risks—particularly physical and transition risks—it still faces significant challenges in fully accounting for nature-related risks, integrating risks comprehensively into capital frameworks, and aligning finance structures with climate action needs. Central banks play a pivotal role in supervising and fostering this evolution to ensure financial stability amid the growing materiality of climate-related risks.

[1] OMFIF's Sustainable Policy Institute Journal, July edition [2] D. A. Carlin and Company [3] European Central Bank [4] Sustainable Fitch

The financial sector is shifting its focus from activities that negatively impact nature to those that mitigate climate change and promote resilience, as outlined in the latest edition of OMFIF's Sustainable Policy Institute Journal.
Sem Housen and Emily Dahl from the United Nations Environment Programme Finance Initiative stress the importance of biodiversity in capital markets, with Marcus Pratsch from DZ BANK agreeing that nature-positive solutions are crucial for the net-zero transition.
Financial institutions have made progress in integrating climate risk into their stress testing frameworks, with all banks including climate risk by 2025, a significant improvement from 2022.
However, many institutions struggle to comprehensively cover all material climate and nature risk drivers, according to William Attwell at Sustainable Fitch.
Accurately determining climate impacts remains challenging, with financial firms facing difficulties in integrating medium- and long-term climate risks within traditional risk management frameworks.
Declines in ecosystem services are now recognized as a material source of financial risk, but many banks have not fully integrated nature-related risks into their internal capital adequacy assessments or stress testing.
Climate shocks, both physical and transition-related, could lead to severe financial losses, and central banks are actively exploring these risks to shape supervisory practices and encourage financial institutions to prepare for climate-related financial shocks.
Central banks play a vital role in supervising and fostering the financial sector's evolution to ensure financial stability amid the growing materiality of climate-related risks, while public finances may be strained by climate change, adding complexity to fiscal sustainability.