ECB Reinforces Climate and Nature Risk Oversight as Physical Hazards Accelerate Across Europe

The European Central Bank has announced a significant expansion of its climate and nature risk oversight framework, signaling a decisive shift from policy development to rigorous supervisory enforcement. Following the successful conclusion of its Climate and Nature Plan 2024-2025, the central bank has outlined three strategic priorities that will define its environmental risk agenda through the remainder of the decade: scrutinizing banks’ transition planning, strengthening physical climate risk assessment, and integrating nature-related financial exposures into regulatory frameworks.

The announcement comes at a critical juncture as climate-related disasters continue to escalate globally. In 2025 alone, global insured losses from natural catastrophes reached unprecedented levels, with the first half of the year recording $100 billion in insured losses—40% higher than the same period in 2024 and more than double the 21st-century average of $41 billion. These mounting financial exposures have prompted regulators worldwide to reassess the systemic implications of environmental degradation for financial stability.

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Two Years of Framework Integration

Over the past two years, the ECB has systematically embedded climate and nature-related considerations across its core functions, transforming what were once peripheral sustainability concerns into central pillars of monetary policy and banking supervision. The institution has made notable progress in reducing emissions from its own operations by 39% in 2024 compared to 2019, demonstrating institutional commitment alongside regulatory ambition.

The central bank has also introduced a climate-related factor into the Eurosystem collateral framework, continued efforts to reduce the carbon footprint of corporate bond holdings, and contributed extensively to climate stress testing and scenario analysis across European banking institutions. These achievements represent foundational work that has positioned the ECB to move into a more assertive phase of environmental risk oversight.

However, the ECB has warned that despite this progress, climate and nature risks are intensifying at a pace that exceeds initial projections. The frequency and severity of extreme weather events, coupled with accelerating biodiversity loss, are creating compounding vulnerabilities across economic sectors and financial markets. This reality has necessitated a recalibration of supervisory priorities to ensure that financial institutions are adequately prepared for the challenges ahead.

Transition Planning Under the Regulatory Microscope

One of the ECB’s most significant priorities going forward will be the comprehensive assessment of prudential transition plans submitted by supervised banks. These plans, which became a regulatory requirement under the Capital Requirements Directive VI in January 2026, must demonstrate credible, actionable pathways for aligning business models with the transition to a low-carbon economy.

Unlike disclosure-focused exercises of the past, the ECB’s approach to transition planning will emphasize operational readiness and financial resilience. Supervisors will conduct detailed analyses of energy transition pathways, evaluate the fiscal and economic costs associated with decarbonization, and assess whether institutions have developed robust risk management frameworks capable of withstanding delayed or disorderly transitions.

The regulatory scrutiny will extend beyond headline commitments to examine the granular details of implementation strategies. Banks will need to demonstrate how they are integrating climate considerations into credit risk assessments, capital allocation decisions, and strategic planning processes. Those that fail to meet supervisory expectations may face binding decisions from the ECB, including potential capital add-ons or restrictions on business activities.

Frank Elderson, Member of the ECB’s Executive Board and Vice-Chair of the Supervisory Board, emphasized that European banks have made significant progress in managing climate and nature-related risks. Whereas in 2019 less than one-quarter of euro area banks had reflected on these risks, they now have an increasing number of advanced practices in place. However, he noted that practices are often only applied to a subset of relevant exposures, geographic areas, and risk categories, highlighting the need for continued supervisory pressure.

The ECB plans to approach transition planning requirements in a gradual and targeted manner, beginning with informal dialogues with banks throughout 2026 to discuss progress, challenges, and areas for improvement. Only in 2027 will the ECB carry out more formal assessments, allowing institutions time to develop comprehensive frameworks while maintaining supervisory oversight throughout the process.

Physical Climate Risk: From Abstract Threat to Concrete Financial Reality

The ECB has signaled that it will significantly strengthen its analysis of physical climate risks, reflecting the growing recognition that extreme weather events are no longer tail risks but recurring features of the economic landscape. These risks increasingly affect loan portfolios, collateral values, and insurance coverage, with direct implications for financial stability across the eurozone.

The intensification of climate-related disasters has created an unprecedented challenge for the insurance sector, with some analysts warning of an emerging “uninsurable future” in high-risk regions. The Los Angeles wildfires of January 2025 alone generated insurance claims estimated at $40 billion, marking the largest insured loss from a wildfire in history. Globally, insurers paid out over $137 billion in weather-related natural catastrophe losses in 2024, significantly exceeding the ten-year average of $98 billion.

These escalating losses are driving profound structural changes in insurance markets. Major carriers have ceased writing new property policies in high-risk states, while premium increases in climate-exposed regions have outpaced national averages. The resulting protection gap—the difference between total economic losses and insured losses—threatens to transfer catastrophic financial burdens onto governments, businesses, and households ill-equipped to absorb them.

For banks, these developments translate into multiple channels of financial risk. Property securing mortgage loans may become uninsurable or prohibitively expensive to insure, affecting both collateral values and borrower creditworthiness. Commercial real estate portfolios face valuation pressures as climate risks are more accurately priced. Infrastructure projects financed by banks may require significantly higher contingency budgets to account for climate adaptation costs.

The ECB’s enhanced physical risk monitoring will include improved macroeconomic analysis, better data availability, and more granular tracking of physical risk exposure across the banking system. Supervisors will assess banks’ operational readiness to manage physical risks, including their ability to incorporate climate hazards such as floods, heatwaves, and droughts into credit risk models, stress testing frameworks, and capital planning processes.

Scenario Analysis and Stress Testing Evolution

Central to the ECB’s enhanced physical risk framework will be the continued refinement of scenario analysis methodologies. The institution has been actively contributing to the development of climate scenarios within the Network for Greening the Financial System (NGFS), an international coalition of central banks and supervisors committed to advancing climate risk management.

The NGFS released its fifth vintage of long-term climate scenarios in November 2024, incorporating significant methodological improvements that better capture the economic impacts of global warming. The updated scenarios, which extend to 2100, paint a sobering picture of potential GDP losses reaching 30% under current policies, with tail risks of up to 50%. These losses represent more than double previous estimates and confirm that physical impacts far outweigh the costs of ambitious transition efforts across all scenarios.

In May 2025, the NGFS published its first set of short-term scenarios covering the period through 2030, designed to provide decision-useful outputs focused on current business cycles and investment horizons. These scenarios explore diverging levels of climate policy action and physical climate risk, with one scenario examining how a sequence of extreme weather events in a single region could generate substantial GDP losses with global spillovers through trade and financial linkages.

The ECB will leverage these enhanced scenario frameworks to conduct more sophisticated stress tests that capture the multifaceted nature of climate risk. The 2026 thematic stress test will include geopolitical risk scenarios that account for how conflict, sanctions, and supply chain disruptions compound climate vulnerabilities. This integrated approach reflects the reality that climate risks rarely materialize in isolation but interact with other sources of macroeconomic and financial instability.

Nature and Water Risks Emerge as Systemic Concerns

Beyond climate, the ECB has confirmed that it will intensify work on nature-related financial risks and ecosystem degradation, with particular attention to water-related vulnerabilities. This expanded focus reflects mounting scientific evidence that biodiversity loss and ecosystem degradation can transmit systemic risks through supply chains, commodity markets, and sovereign exposures.

Research published by the OECD in 2025 found that water-related economic risks are estimated to be equivalent to 7 to 9% of global GDP, the highest among ecosystem services. Over 90% of natural disasters are weather and water-related, including droughts, floods, wildfires, and pollution events. Agriculture alone accounts for approximately 70% of global freshwater withdrawals, making food security and agricultural lending highly vulnerable to declining water availability.

The ECB’s analysis has identified water-related risks as particularly material for the euro area economy. A study examining the deep interconnectedness between nature and the eurozone economy found that water scarcity or ecosystem degradation in one region can have disproportionate impacts on specific sectors, firms, and financial portfolios. Approximately one-quarter of the euro area economy could be at risk from these nature-related vulnerabilities.

Water risks manifest through multiple channels. Physical risks include scarcity, flooding, pollution, and ecosystem degradation, each capable of disrupting economic activity and financial performance. Transition risks arise from regulatory changes, technological shifts, and evolving societal preferences related to water management and conservation. Litigation risks emerge as communities and governments increasingly pursue legal action against entities contributing to water stress or ecosystem damage.

The financial sector’s exposure to water risks extends across traditional risk categories. Credit risk materializes when borrowers dependent on water-intensive activities face declining revenues or increased costs due to water scarcity or quality degradation. Market risk emerges from asset revaluations as water constraints are factored into pricing. Operational risk manifests when financial institutions’ own facilities face water-related disruptions. Liquidity risk can develop if depositors or investors lose confidence in institutions with concentrated exposures to water-stressed regions or sectors.

Integrated Supervisory Architecture for Environmental Risk

The ECB’s updated priorities will be implemented through an integrated supervisory architecture that embeds environmental risk considerations across all dimensions of banking oversight. This represents a fundamental departure from treating climate and nature risks as standalone issues toward recognizing them as cross-cutting factors that interact with traditional risk categories.

As part of the ECB’s supervisory priorities for 2026-2028, climate and nature risks feature prominently alongside geopolitical uncertainties and digital transformation challenges. The supervisory program includes targeted follow-up on remaining shortcomings from the 2022 thematic review and climate risk stress test, thematic reviews of banks’ transition planning aligned with new regulatory requirements, horizontal assessments of Pillar 3 disclosure compliance for environmental, social, and governance issues, and targeted on-site inspections focused on climate and nature risk management.

Joint Supervisory Teams will integrate climate and nature risk assessments into their regular supervisory activities, rather than treating them as separate exercises. This mainstreaming approach ensures that environmental risks receive consistent attention across all supervised institutions and that supervisory responses are appropriately tailored to each bank’s specific risk profile and business model.

The ECB also plans to update its compendium of good practices for climate and nature risk management, building on insights gathered from banks across Europe. This benchmarking tool enables supervisors to identify leading practices and encourages lagging institutions to accelerate their risk management improvements. The compendium covers areas including governance structures, risk identification methodologies, data and modeling capabilities, scenario analysis frameworks, and disclosure practices.

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Monetary Policy Integration and Collateral Framework

The ECB’s climate and nature agenda extends beyond banking supervision to encompass monetary policy operations and the management of the Eurosystem’s balance sheet. Climate considerations are now integrated into macroeconomic assessments and projections, with transition policies such as the Emissions Trading System 2 incorporated into the central bank’s analytical framework.

The Eurosystem’s collateral framework has been adjusted to reflect climate-related factors, with disclosure requirements introduced for eligible collateral from 2026 onward. These measures aim to incentivize improved climate risk management and transparency among entities seeking to use their assets as collateral in ECB monetary operations. The central bank has also continued efforts to reduce the carbon footprint of its corporate bond holdings, demonstrating how portfolio management decisions can support the transition to a sustainable economy without compromising the primary objective of price stability.

The updated monetary policy strategy statement published in 2025 explicitly acknowledges the implications of nature degradation for monetary policy, marking a significant evolution in how the ECB conceptualizes its mandate. This recognition reflects the understanding that ecosystem degradation and climate change have profound implications for price stability through their impacts on the structure and cyclical dynamics of the economy.

Data, Disclosure, and Analytical Capacity

Underpinning all of the ECB’s environmental risk initiatives is a sustained effort to improve data availability, quality, and analytical capacity. The central bank has regularly expanded and updated its climate change-related indicators, providing market participants and policymakers with enhanced transparency regarding emissions, sustainable finance flows, and physical climate hazards.

However, significant data gaps persist, particularly regarding nature-related risks and the spatial distribution of physical climate exposures. The ECB has called for enhanced corporate disclosures aligned with emerging standards such as the Corporate Sustainability Reporting Directive, which expands reporting requirements to medium-large undertakings while maintaining proportionality.

The institution is also investing in advanced modeling capabilities that can capture the complex, non-linear relationships between environmental degradation and economic outcomes. This includes exploring tipping points in climate and ecological systems that could trigger abrupt shifts with cascading financial consequences. The academic debate surrounding the methodologies used in the latest NGFS scenarios underscores both the progress made and the uncertainties that remain in quantifying environmental risks.

Building analytical capacity extends beyond the ECB itself to encompass supervised banks and the broader financial ecosystem. Many institutions lack the specialized expertise needed to assess water risks, biodiversity dependencies, or climate adaptation needs. The ECB is supporting capacity-building initiatives, knowledge-sharing workshops, and technical assistance programs to address these capability gaps.

International Coordination and Standard-Setting

The ECB’s climate and nature agenda operates within a broader landscape of international coordination among financial regulators. The institution actively participates in the NGFS, the Financial Stability Board, and other international forums where climate risk methodologies and supervisory practices are harmonized.

This international engagement serves multiple purposes. It ensures that European approaches remain aligned with global best practices, facilitates the development of comparable risk metrics across jurisdictions, and strengthens the collective response of the financial system to global environmental challenges. The ECB’s leadership in scenario design and analysis within the NGFS has helped establish common analytical frameworks that enable consistent risk assessment across diverse financial systems.

The emergence of disclosure frameworks such as the Taskforce on Nature-related Financial Disclosures represents another dimension of international coordination. These initiatives seek to standardize how companies and financial institutions measure and report their dependencies on nature and their impacts on ecosystems, providing the data foundation necessary for effective risk management.

Economic Implications and Systemic Risk Assessment

The ECB’s intensified focus on environmental risks reflects a fundamental reassessment of the relationship between ecological systems and financial stability. Climate change and nature degradation are no longer viewed as long-term, uncertain threats but as present-day drivers of economic volatility and financial vulnerability.

The costs of inaction are substantial and accelerating. The UN Office for Disaster Risk Reduction estimates that total disaster costs now exceed $2.3 trillion annually when indirect and ecosystem impacts are included—nearly ten times the annual direct losses reported in official figures. Without urgent action to close the gap between rising risks and inadequate investment in resilience, the financial and economic consequences will become increasingly difficult to manage.

For the eurozone, these global trends manifest through multiple channels. European banks have significant exposures to climate-vulnerable regions through international lending and investment portfolios. Supply chain disruptions caused by extreme weather in Asia or Africa can affect European manufacturers and service providers. Migration pressures resulting from climate-induced displacement could generate fiscal and social challenges that feed back into sovereign risk assessments.

The transition to a low-carbon economy also presents economic opportunities alongside risks. Europe’s commitment to achieving net-zero emissions by 2050 requires massive investment in renewable energy infrastructure, energy efficiency improvements, and new technologies. The ECB’s work on transition planning aims to ensure that the financial sector can effectively support this transformation while maintaining stability and avoiding the emergence of new vulnerabilities.

Looking Ahead: From Framework to Implementation

The ECB’s announcement marks a clear inflection point in how environmental risks are integrated into central banking and financial supervision. The shift from framework development to rigorous implementation reflects both the progress achieved over recent years and the urgency demanded by accelerating environmental degradation.

Banks will face heightened scrutiny across multiple dimensions of their environmental risk management. Governance structures must demonstrate board-level ownership of climate and nature risks. Risk identification processes must capture physical, transition, and nature-related exposures comprehensively. Data and modeling capabilities must evolve to support forward-looking analysis. Stress testing frameworks must incorporate climate scenarios and nature dependencies. Capital and liquidity planning must account for potential shocks from environmental events. Disclosure practices must provide stakeholders with transparent, decision-useful information.

Institutions that have proactively invested in climate and nature risk management capabilities will be better positioned to meet these supervisory expectations. Those that have treated environmental risks as compliance exercises rather than strategic priorities may face more significant challenges in demonstrating adequate preparedness.

The ECB has emphasized that its enhanced supervisory approach will be proportionate, taking into account the size, complexity, and risk profile of individual institutions. Smaller banks with limited exposures to climate-vulnerable sectors or regions may face less intensive scrutiny than large, internationally active institutions with diverse portfolios spanning multiple geographies and asset classes.

Broader Policy Implications

While the ECB’s mandate focuses on financial stability and price stability, the effective management of environmental risks requires complementary action across the policy landscape. Water governance, land use planning, climate adaptation investment, and ecosystem protection are primarily the responsibility of other authorities, yet they fundamentally shape the risks that financial institutions face.

The ECB has called for enhanced coordination between financial regulators, environmental agencies, and water management authorities to ensure that financial stability objectives and environmental sustainability goals are mutually reinforcing. This includes aligning financial flows with policies that support water security and ecosystem protection, strengthening disclosure standards and taxonomies that guide capital allocation, and developing coherent supervisory instruments that promote resilience across interconnected systems.

The Corporate Sustainability Due Diligence Directive adopted by the European Union in 2024 represents one example of complementary policy action. By requiring large companies to identify and address adverse environmental impacts throughout their value chains, including water pollution and ecosystem degradation, the directive creates incentives for improved environmental performance that can reduce financial risks over time.

Conclusion: Environmental Risk as Core Financial Stability Concern

The European Central Bank’s intensified focus on climate and nature risks reflects the evolution of these issues from peripheral sustainability concerns to core drivers of financial stability. The central bank’s comprehensive approach—spanning transition planning, physical risk assessment, nature-related exposures, scenario analysis, and supervisory integration—demonstrates the multifaceted response required to address environmental challenges effectively.

As extreme weather events become more frequent and severe, as ecosystems face mounting pressures, and as societies grapple with the complex challenge of transitioning to sustainable economic models, financial institutions must adapt their risk management frameworks accordingly. The ECB’s supervisory priorities for the coming years provide a clear roadmap for this adaptation, balancing the need for financial resilience with support for the broader green transition.

The next phase of implementation will test whether the frameworks developed over recent years can deliver the resilience and foresight necessary to navigate an increasingly unstable environmental landscape. Success will require sustained commitment from regulators, financial institutions, policymakers, and society at large to ensuring that economic prosperity and environmental sustainability advance together rather than in opposition.

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By: Montel Kamau

Serrari Financial Analyst

27th January, 2026