EU bank's green shift: leading with climate strategy 

Climate change is increasingly recognized not only as an environmental and social challenge but also as a major financial and economic risk, and a strategic opportunity. For financial institutions especially, understanding and managing exposure to climate-related risks has become imperative. These risks can present a dual challenge for the sector: the increasing frequency of physical events like floods and heatwaves, and the systemic shifts required to transition to a low-carbon economy. For EU banks, managing both dimensions is no longer optional, but instead it is a strategic necessity as these dynamics impact all core banking functions, from lending and investment to private banking and advisory.

Recent data from the European Banking Authority (EBA) shows that over 70% of EU banks’ exposures are to high-emission sectors, underscoring the scale of transition risk. Meanwhile, only 3% of assets currently qualify as green under the EU Taxonomy, highlighting the untapped potential for sustainable finance.¹

Failure to assess and integrate climate risks poses a significant threat to the financial stability and resilience of banks. For instance, the European Supervisory Authorities and the European Central Bank (ECB) estimate that EU banks could face aggregate losses ranging from €340 billion to €640 billion,² representing 6% to 11% of total credit exposures, depending on the specific climate scenario considered. These losses primarily stem from deteriorating asset quality and increased default rates in sectors vulnerable to climate change. Research indicates that firms exposed to climate-related disasters are up to 30% more likely to default on their loans³ in the two years following such events. This increased default risk is primarily due to the impacts on physical assets and ongoing operational disruptions. Banks that fail to anticipate and manage these risks may face significant financial losses, reputational damage, and regulatory sanctions.  Supervisory expectations are emphasizing the need for robust climate risk governance, scenario analysis and the integration of climate considerations into credit risk assessments and capital planning.

Current regulatory landscape

Regulators are stepping up efforts to decarbonize the banking sector through new rules and frameworks. In Europe, key initiatives aim to address climate-related financial risks and promote sustainable finance. The EBA has introduced Pillar III disclosure requirements, obligating banks to report on climate exposures, mitigation actions, and alignment with sustainability goals to enhance transparency and market discipline.

Complementing this, the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy Regulation require financial institutions to publish credible transition plans with measurable targets and timelines. These frameworks ensure that institutions demonstrate how their strategies contribute to climate mitigation and adaptation.

At the global level, the International Sustainability Standards Board (ISSB) has launched IFRS S1 and S2, effective from January 2024, setting a global baseline for sustainability reporting. IFRS S2 focuses on climate-related governance, strategy, risk management, and metrics, and is designed to align with EU standards like CSRD and ESRS.

The ECB has issued climate-related supervisory expectations, including stress tests and reviews to assess banks’ preparedness. Locally, Luxembourg’s CSSF requires financial institutions to integrate sustainability risks into governance and risk management.

The regulatory landscape still remains complex. Differing national commitments and shifting political priorities create uncertainty, posing challenges for institutions striving to align with evolving sustainability standards.

Understanding climate risks and the climate transition plan

Climate risks refer to the potential negative impacts that climate change can have on an organization’s operations, financial performance, and overall stability. These risks can be categorized into two main types: physical risks and transition risks. Physical risks arise from climate-related events such as extreme weather conditions, rising sea levels, and chronic climate changes that can directly affect asset values, supply chains, and operational continuity. Transition risks, on the other hand, are linked to the movement towards a low-carbon economy and can arise from regulatory changes, shifts in market preferences, or technological disruptions.

To address these challenges, financial institutions must conduct comprehensive climate risk assessments. This process involves identifying and quantifying vulnerabilities across their portfolios, analyzing how various climate scenarios could impact their operations. Tools such as climate risk stress testing and scenario analysis are essential for evaluating the financial implications of potential climate-related events. Additionally, engagement with stakeholders, including clients and industry experts, enables firms to gain insights into sector-specific vulnerabilities and better understand how climate risks may evolve over time.

To adequately respond to the consequences of climate risks, companies should implement a climate transition plan, a strategic framework that outlines their pathway toward decarbonization. This plan not only defines the steps needed to align with a low-carbon economy but also serves as a proactive tool for managing climate-related risks.

A credible and effective transition plan should include five key elements:

1. GHG Emission reduction targets: clear, science-based targets aligned with global climate goals
2. Identification of the decarbonization levers: including both operational and financial strategies
3. Strategic integration: ensuring the plan aligns with the institution’s core business model and long-term strategy
4. Governance of climate issues: defining roles, responsibilities, and oversight mechanisms
5. Monitoring and verification: regular progress tracking, supported by external assurance

Banks have a powerful role in driving decarbonization, primarily through the composition of their financing portfolios. By shifting capital away from high-emission sectors and actively engaging with these industries to support their transition, banks can significantly influence the pace of the climate transition. Rather than simply divesting, forward-looking institutions are helping carbon-intensive sectors adopt low-carbon technologies and practices. Additionally, banks are innovating with sustainable financial products, such as green bonds, sustainability-linked loans, and climate-focused investment funds, to direct capital toward environmentally beneficial outcomes.

Internally, banks must also address their own operational emissions. While Scope 1 and 2 emissions are typically smaller than financed emissions, they remain important. Actions like improving energy efficiency, transitioning to electric vehicle fleets, and sourcing renewable energy contribute to a more sustainable operational model.

To guide their transition strategies, banks can rely on a suite of tools. The Partnership for Carbon Accounting Financials (PCAF) helps measure financed emissions, the Science Based Targets initiative (SBTi) supports setting science-aligned targets, Paris Agreement Capital Transition Assessment (PACTA) evaluates portfolio alignment with climate scenarios, and the Accessing Climate Transition (ACT) framework assesses the credibility of transition plans. Since no single framework captures all dimensions of the transition, institutions should adopt a tailored, multi-tool approach to build robust and credible climate strategies.

Ultimately, a structured climate transition plan not only addresses regulatory compliance but also positions institutions to capitalize on emerging opportunities in the green economy. By integrating sustainability into their core business strategies, financial firms can enhance their resilience against climate-related disruptions while fostering long-term value creation.

The strategic benefits of climate risk integration

Implementing transition plans and decarbonizing investment portfolios can often lead banks to achieve better financial returns. Strategies favoring low-carbon and ESG best-practice firms for example, can help banks reduce portfolio default risk (PD) while enhancing returns. A recent study by MSCI⁴ analyzed the performance of ESG-rated companies in developed markets over 17 years and in emerging markets over 11 years. The findings revealed that top-rated ESG companies consistently outperformed their lower-rated counterparts, driven primarily by stronger earnings fundamentals rather than valuation expansion. Furthermore, early adopters of climate risk strategies can set themselves apart in the market, appealing to environmentally conscious customers.

Banks would benefit from starting to:

1. Assess their exposure to climate risks, identifying the material ones
2. Quantify the potential impacts of climate-related risks on their operations and financing portfolios
3. Integrate climate considerations into their existing Risk Management Framework and financing decisions
4. Formalize their transition plan: set targets, identify key decarbonization actions and monitor their progress over time

 Adopting proactive climate strategies contributes to the long-term resilience of financial players. By being better prepared to navigate the uncertainties of a changing climate and regulatory landscape, these organizations can mitigate potential losses while unlocking new opportunities for operational efficiency, investment attraction, and sustainable growth.

For banks, the transition to a low-carbon economy will require time, strategic planning, and sustained governance. Boards and business leaders must take ownership now, embedding climate risk into core banking operations, risk frameworks, and long-term growth strategies through continuous monitoring and accountability.