In a new report issued by the Financial Stability Board (FSB), the organization examines the potential impact of climate change on the global financial system, and highlights the potential risks to financial stability in the future.

The FSB is an international body mandated with the promotion of global financial stability, through coordination with national financial authorities and standard setting bodies. The new report assesses the physical and transition risks associated with climate change and global efforts to fight, mitigate and cope with it.  

On the physical risk side, the FSB notes that current estimates of the impact on asset prices appear relatively contained, but warns that they may be subject to significant tail risks. As an example, the report notes that while the central estimate of the reduction in asset prices that would result from a 2.5ºC increase in temperatures by 2105 is a relatively modest 1 – 1.8%, the tail risks are significantly higher, with a 5% probability of a reduction greater than 4.8%, and a 1% probability of 16.9% – equivalent to a difference of more than $20 trillion.

The report also warns of the potential destabilizing effect of a disorderly transition to a low carbon economy. According to the report:

“Such a disorderly transition might be brought about by sudden changes in technology. It could also be triggered by an unexpected change in public policy. Such radical policy action might arise due to the increased materialisation of physical risks.”

In the examples cited above, the FSB notes that physical and transition risks could potentially combine and exacerbate the impact on financial stability. Additional transition risks could also include changes in asset prices resulting from reallocation from capital from energy intensive industries towards less carbon intensive sectors.

The FSB report includes recommendations for institutions and authorities to mitigate the impact of climate change-related risks on financial stability. Suggestions include heightened due diligence and screening by financial institutions when considering lending to firms, along with increased engagement with on the part of investors with portfolio companies to promote emission reductions in their businesses. The FSB also recommends using metrics, such as those outlined by the TCFD framework to identify the emissions profiles of companies. Additionally, the FSB recommends that financial authorities assess how the financial firms under their supervision are managing climate risks, and take steps to better understand the firms’ exposures to those risks.