4  Economic losses from climate-related extremes in Europe, European Environment Agency, February 2022. 1  European Commission estimates, in its 2020 report,5 that a global temperature increase of 3°C could result in an annual welfare loss of around 1.4% of GDP in Europe, with the greatest impact arising in southern Europe. Meanwhile, transition risks relate to the costs that may arise during the transformation of the economy needed to mitigate climate change and minimise the impact of the physical risks. The implementation of public policies necessary to achieve these objectives, the development of less contaminating technological innovations and changes in consumer preferences in favour of lower-emission goods and services will lead to a reallocation of resources between sectors. If this is not a sufficiently smooth process there could be significant economic disruption. Channels of transmission to financial institutions Financial institutions are exposed to the above-mentioned risks both directly and indirectly. This issue has been addressed by various studies and institutions. For example, in the banking field, the Basel Committee on Banking Supervision (BCBS) published a paper in April 20216 dividing transmission channels into two groups: microeconomic and macroeconomic. Microeconomic channels refer to the effect that the above-mentioned risk factors may have on institutions’ counterparts (borrowers). Macroeconomic channels refer to the negative effect that physical and transition risks may have on economic growth, which would also affect financial institutions. To illustrate these channels, transition risks may, for instance, arise from the introduction of green taxes, which would raise energy costs.

From a more macro perspective, these risks may impair productivity and also cause a reallocation of resources, not only of physical capital, but also of labour, through migration. Special features of climate change risk factors In general, these risks can be considered to manifest themselves in financial institutions through the traditional financial risk categories (credit, market, liquidity, operational and reputational risk). However, climate change incorporates some fundamental special features into these traditional risks, which must be taken into account if they are to be managed and supervised appropriately.7 First, the consequences of climate change are unprecedented and will occur over a very prolonged period. Historical experience is thus of little use to assess their magnitude and evolution, and therefore the uncertainty associated with how and when they will materialise is very high. Second, that uncertainty is exacerbated by the fact that the physical and transition risks are interrelated non-linearly, and possibly subject to tipping points. This, in essence, means that the magnitude of the effects of their materialisation could be greater than expected and will affect economic agents more generally and more abruptly than other risks. Third, the problem has a global dimension. There is little any one country can do on its own to avoid the problem and there may always be free-riders. That is why utmost collaboration and cooperation are required. International organisations and institutions therefore need to play a key role in this area.