From climate risk management to resilient financial performance

Climate risk is now central to financial and regulatory risk management and strategy for financial institutions and export credit agencies (ECAs), supporting resilient performance and compliance amid fragmented global policies. Robust governance frameworks are essential to ensure consistent implementation and alignment with regulatory and stakeholder expectations.

Why climate risk management matters for financial institutions and ECAs

Effective climate risk management is becoming essential for ECAs as they navigate the intersection of public policy and resilient financial performance.

In addition to the challenges financial institutions (FIs) face, ECAs manage additional complexity due to their mandate to support exporters, including those exposed to climate risks, while managing related climate risks.

A structured, three-pillar framework – encompassing transactional credit risk, portfolio stress testing, and climate risk appetite – can help financial institutions and ECAs strengthen their resilience, support well-governed, informed decision-making, and deliver on both commercial and public mandates in an increasingly uncertain world.

Portfolio stress testing: Building resilience in a changing climate

Climate change is acknowledged as a material financial risk by regulators such as the Bank of England, the UK’s Prudential Regulatory Authority (PRA), in line with the Basel Committee’s climate risk principles, as well as the Financial Stability Board and the Network for the Greening of the Financial System (NGFS). UKEF’s commitments under the Task Force on Climate-related Financial Disclosures (TCFD), which have become mainstream with its transition to ISSB as IFRS S2, and HM Treasury guidelines require regular scenario analysis and stress testing to assess the resilience of UKEF’s portfolio to climate-related risks. NGFS scenarios highlight that GDP losses from chronic physical risks could reach 8-14% globally by 2050, with transition risks adding further fiscal strain. The Potsdam Institute states that climate change could cut global income by roughly 19% by 2049 (a range of 11-29%), with USD 38 trillion lost annually, if we fail to act. The Bank of England concludes that managing climate risk is important to avoid a 10-15% profit drag and GBP 110 billion extra losses in delayed transition.

In this context, UKEF has developed a global climate stress test model which projects changes in credit ratings under various NGFS scenarios.

UKEF continuously improves and updates its climate stress test model with the latest scenarios, methodological improvements, and enhancements in geographical and sectoral granularity. Geopolitical instability underscores the need to keep scenarios relevant and ensure robust transmission channels, particularly for transition risks, alongside high-quality data and portfolio-data classification that sufficiently segregates transactions into transition-risk-relevant sectors.

The development of the model involves not only collaboration across UKEF, but also academia and other government and public bodies. Of particular importance is the resulting analysis that should inform strategic decision making regarding both risks and opportunities across the organisation. Sector and regional deep dives to understand where risk is concentrated under different scenarios are crucial to make stress testing results insightful and useful for future decision-making.

The importance of integrating climate risk into transactional credit decisions

Consideration of material climate risks is essential for both FIs and ECAs to effectively manage financial performance. In addition, ECAs such as UKEF are mandated to support national exporters – including those in hard-to-abate sectors and in climate-vulnerable regions – while also aligning with national and international decarbonisation goals. Achieving these objectives must also be aligned with the relevant ECAs’ mandated financial performance requirements.

Delivering on these objectives requires a tailored approach to credit risk analysis and must be supported by clear governance structures. Integrating material climate and ESG risks into credit assessments is essential; failure to do so can threaten financial sustainability.

Recognising that traditional ratings agency approaches are not designed for ECA business, UKEF is developing a framework for managing climate risk across its portfolio and pipeline of sovereign deals. This will involve transparent, evidence-based analysis of the specific climate risks that impact different markets across the globe. A consultative, organisation-wide approach ensures feedback from commercial, policy, and risk specialists is fully addressed, enabling UKEF to manage risks effectively while fulfilling its mandate.

Similarly, UKEF continues to improve its non-sovereign credit risk, though the prioritisation of sovereign ratings reflects the longer tenor, greater materiality of climate risks, and stronger alignment with national mandates. Non-sovereign transactions, often shorter in duration and more operationally diverse, pose less systemic climate risk and face greater methodological challenges in climate risk quantification. As modelling techniques and data availability improve, UKEF will continue to refine its approach across all credit categories.

Defining and governing climate risk appetite

Risk appetite provides guardrails and sets tolerance levels. For climate risk appetite, different approaches and metrics are explored by the Bank of England’s Climate Financial Risk Forum (CFRF) or International Association of Credit Portfolio Managers (IACPM). To ensure this is useful for future organisational decision-making, UKEF considers its specific circumstances, mandate, and resulting diverse, global, and long-term portfolio, as well as putting in place robust governance, including Board-level oversight.

A forward-looking approach was considered most effective for assessing and managing UKEF’s tolerance to climate-related financial risks. Heightened geopolitical volatility has increased transition risk, underscoring the importance of understanding the long-term impact of climate risk on expected losses and making informed decisions about risk mitigation, resource allocation, and strategic planning. By considering risk-mitigating capacity, namely unutilised risk capital, climate risk appetite helps safeguard UKEF’s long-term financial interests. While UKEF is not regulated, this approach aligns with regulatory expectations from the Bank of England and the PRA.

Depending on available data, portfolio characteristics, and the scope for portfolio rebalancing, climate-related Expected Losses – or more complex approaches like Climate Value at Risk or climate-adjusted Expected Shortfall – could be considered. Establishing good governance is important; for example, Board-level review of climate risk reports and clear senior management accountability for climate risk supports embedding it into the enterprise risk framework, ensuring climate-risk resilient financial performance over time. Providing an outlook that helps manage the portfolio within climate risk tolerance is key to maintaining stakeholders’ confidence.

Delivering climate-resilient performance

Resilient financial performance is based on understanding these risks through effective risk management, including material climate risks. By integrating climate considerations into transactional credit ratings, ECAs can support exporters in vulnerable sectors without compromising sound risk management. Portfolio-level stress testing reinforces accountability – not only to shareholders, but also to governments and taxpayers – by quantifying long-term climate exposures. Meanwhile, a well-defined climate risk appetite bridges the gap between mandate and prudence, guiding capital allocation in line with climate resilience.

Together, these pillars and related governance empower ECAs like UKEF to fulfil their mission and maintain stakeholder confidence in an increasingly climate-impacted world.

To translate these principles into practice, risk leaders should focus on the following actions:

• Portfolio stress testing: Conduct regular climate stress testing to quantify exposures and inform capital allocation.
• Transactional credit risk: Embed climate risks in credit decisions to ensure accurate pricing and long-term resilience.
• Climate risk appetite: Set and review climate risk appetite with clear metrics and governance aligned to your mandate.
• Mandate balance (ECAs): Balance support for exporters with prudent risk management.
• Collaboration (cross-cutting): Promote cross-team collaboration amongst commercial, policy, and risk-focused colleagues to pursue ECA mandates whilst delivering resilient performance.

By embedding governance at the heart of these climate risk management pillars, Chief Risk Officers and risk professionals can ensure that these risk management strategies are not only well-designed but also effectively implemented and monitored.