Rémy Estran is managing director of EDHEC Scientific Climate Ratings and Camille Angué is deputy director of the EDHEC Climate Institute

From flash floods in Spain to wildfires in California, mortgage-backed securities have never been more exposed to physical climate risk. Financial institutions are increasingly on the front lines, facing immediate consequences such as collateral devaluations, rising loan impairments and mounting credit risk. Yet these episodes are soon forgotten: one news cycle chases the next, even as the financial scares persist.

Another emerging trend is the compounding impact of transition risks, driven by the rapid decline of carbon-intensive sectors, regulatory pressures and shifting investor expectations. As carbon-intensive industries rapidly lose access to capital, major European banks have been forced to write down loans and investments as they exit these sectors.

These risks are no longer peripheral. Climate and environmental threats are now considered material financial risks. This reality has become an official supervisory concern in Europe, with the European Central Bank moving from guidance to enforcement. Banks are no longer merely encouraged to consider climate factors; they are required to embed them into their governance, strategy, risk management and capital planning processes.

Following its 2022 Thematic Review on Climate and Environmental Risks, the ECB laid out a clear three-step timeline: banks had to categorise climate and environmental risks and assess their materiality by March 2023; embed them into governance, strategy and risk management frameworks by the end of 2023, or face binding supervisory decisions and possible penalty payments; and achieve full integration into capital planning and stress testing by the end of 2024. Moving forward, climate risk is sure to be a top supervisory priority for the ECB.

However, integrating climate risk into financial practice is complex. Despite progress in modelling and stress testing, significant limitations persist.

Physical risk data thus often relies on proxies, which fail to capture actual exposure across operational sites. Due to limitations in internal IT systems, some banks evaluate physical risk based solely on the address of a borrower’s headquarters, which is clearly misleading for companies operating globally. In other cases, financial institutions assess only the production sites directly linked to the loans they have issued, overlooking other critical facilities that may still be essential to their counterparties’ overall business and repayment capacity.

“Transition risk has evolved faster than the models designed to measure it.”

Transition risk modelling suffers similar flaws. Although energy performance certificates are legally required in real estate transactions, for example, they are often missing from banks’ central databases. This hinders their inclusion in loan-level risk models, despite energy efficiency being a key transition risk factor affecting property values. Now that EPC ratings have a clear effect on the valuation of real estate collateral, banks should move to systematically collect and integrate this data into their valuation and risk models. In this sense, transition risk has evolved faster than the models designed to measure it.

Apart from data, another major flaw lies in the climate scenarios themselves. Supervisors currently require banks to test against an “orderly transition” scenario aligned with net zero targets by 2050. Yet research highlights the extremely low probability of this scenario, given current emissions trajectories and policy inertia. As such, banks are in effect stress testing against a hypothetical yet unlikely future, reducing the practical value of these exercises.

The resulting inconsistency between institutions very clearly resembles credit risk modelling before the ECB’s targeted review of internal models, or TRIM. Without standardisation, climate stress tests remain non-comparable across banks, which could prompt a climate-focused TRIM in the near future.

In response to these challenges, several private and academic institutions are designing tools to enhance the quantification of climate risks, translating scientific insights into financially relevant metrics, which could eventually be integrated into financial institutions’ risk frameworks.

This is the case of EDHEC Business School in France, which is launching a risk rating agency, Scientific Climate Ratings, focused on the financial materiality of climate impacts, the academic foundations of which will be openly accessible from June.

The goal is to enable financial institutions to act. Institutions that treat climate risk management as a purely defensive or compliance-driven task are falling behind. In contrast, those that invest in robust modelling and data-driven strategies can build a real competitive advantage.

This means developing tailored transition finance products to support clients’ decarbonisation and resilience strategies: encouraging borrowers to safeguard asset quality and investors to expand portfolios that align risk, return, and climate integrity.

The transition is not just a risk to be managed. It is an opportunity to lead.