Climate risk in expected credit losses

Banks were among the first to be asked by supervisors how climate change affects their numbers, and expected credit losses are where the question bites. The difficulty is matching long-term climate effects with loan lives and models built on historical data, which contain little evidence of either floods of new severity or the phase-out of whole industries. This guide explains where climate enters the ECL calculation, works through three portfolios, and covers overlays, supervisory expectations, non-banks and disclosures.

By Mirza Fahad Baig, Chartered Accountant. Reviewed by Hamza Fida, Chartered Accountant. 4 minute read.

Short answer

Climate risk in expected credit losses is reflected through the normal IFRS 9 model, not a separate one. Physical risks, such as floods and droughts, and transition risks, such as carbon prices, regulation and falling demand, can raise borrowers' probability of default, reduce collateral values and so increase loss given default, change expected drawdowns, and cause a significant increase in credit risk that moves loans to stage 2 and lifetime losses. IFRS 9 requires reasonable and supportable forward-looking information, so climate effects belong in the forecasts and scenarios where they are material over the life of the loans; where models cannot capture them, banks use post-model adjustments, or overlays, which they must explain. European supervisors expect climate and environmental risks in credit risk management, and the EBA's ESG risk guidelines have applied to most banks since 11 January 2026. In this guide's example, climate adjustments raise a bank's ECL on three portfolios from EUR 3.6 million to EUR 19.4 million, mostly from moving coal power loans to stage 2.

At a glance

Model
Normal IFRS 9 ECL
Affects
PD, LGD and staging
Physical risk
Floods, drought, heat
Transition risk
Carbon costs, demand
Where models fall short
Explained overlays
Disclose
Key assumptions
Climate risk in expected credit lossesModel: Normal IFRS 9 ECL; Affects: PD, LGD and staging; Physical risk: Floods, drought, heat; Transition risk: Carbon costs, demand; Where models fall short: Explained overlays; Disclose: Key assumptions.KEY FACTS AT A GLANCEClimate risk in expected credit lossesModelNormal IFRS 9 ECLAffectsPD, LGD and stagingPhysical riskFloods, drought, heatTransition riskCarbon costs, demandWhere models fall shortExplained overlaysDiscloseKey assumptionsTax BakersClimate risk in expected credit lossesModel: Normal IFRS 9 ECL; Affects: PD, LGD and staging; Physical risk: Floods, drought, heat; Transition risk: Carbon costs, demand; Where models fall short: Explained overlays; Disclose: Key assumptions.KEY FACTS AT A GLANCEClimate risk in expected creditlossesModelNormal IFRS 9 ECLAffectsPD, LGD and stagingPhysical riskFloods, drought, heatTransition riskCarbon costs, demandWhere models fall shortExplained overlaysDiscloseKey assumptionsTax Bakers
Key facts at a glance, as set out in this guide.

How does climate risk affect expected credit losses?

Expected credit losses are the probability-weighted present value of cash shortfalls, usually built from the probability of default (PD), loss given default (LGD) and exposure at default (EAD). Physical risks can damage borrowers' assets and income and reduce the value or insurability of collateral; transition risks can squeeze the profits of carbon-intensive borrowers, strand their assets and make refinancing harder. IFRS 9 requires all reasonable and supportable information about past events, current conditions and forecasts, available without undue cost or effort, so material climate effects within the life of the exposures must be included. See IFRS 9 expected credit loss and ECL step by step.

Where does climate enter the ECL model?

  • PD: sector and borrower ratings that reflect carbon costs, transition plans and physical exposure.
  • LGD: collateral values adjusted for flood risk, energy performance and insurance availability.
  • EAD: higher drawdowns on facilities by borrowers under stress.
  • Staging: climate events or downgrades of a sector's outlook can be a significant increase in credit risk, moving loans to stage 2 and lifetime ECL. See ECL stages explained.
  • Scenarios: macroeconomic scenarios that include carbon prices and physical damage, weighted by probability. See macroeconomic scenarios.

The life of the exposure sets the horizon: a 25-year mortgage book is exposed to long-term physical risk, while a one-year trade finance book mainly to near-term transition shocks.

Climate risk in expected credit losses: a bank's three portfolios

A bank reviews three portfolios, in EUR million of exposure, comparing ECL before and after climate adjustments.

PortfolioEADPD, before and afterLGD, before and afterECL before, EUR thousandECL after, EUR thousandClimate effect
Mortgages in flood-prone areas8000.8% to 1.0%10% to 20%6401,60012-month PD up; LGD doubles as property values and insurance fall
Loans to coal-fired power producers3001.5% to 12.0%40% to 45%1,80016,200Significant increase in credit risk: stage 2, lifetime PD
Farm loans in drought regions2002.0% to 2.6%30% to 30%1,2001,56012-month PD up after lower forecast yields
Total1,3003,64019,360
ECL before and after climate adjustments (EUR thousand)ECL before and after climate adjustments (EUR thousand)6401,600Flood-zone mortgages1,80016,200Coal power loans1,2001,560Drought-region farmsBefore climate adjustmentsAfter climate adjustments
Moving one portfolio to stage 2 outweighs all the other effects.

For the mortgages, flood maps and insurers' withdrawal from high-risk areas lower expected sale values, doubling LGD. The coal power loans are the largest effect: a new national phase-out date makes the borrowers' plants uneconomic before the loans mature, a significant increase in credit risk, so the bank moves them to stage 2 and measures lifetime losses with a lifetime PD of 12%. The farm loans see a modest rise in PD from lower forecast yields. Total ECL rises from EUR 3,640 thousand to EUR 19,360 thousand. The bank builds the mortgage and farm effects into its models, but holds the coal adjustment as a documented overlay until its rating models are recalibrated.

Should banks use overlays for climate risk?

Overlays are acceptable when models cannot yet capture an effect, but they should be specific, quantified, approved through governance, and replaced by model changes over time. Supervisors have criticised generic climate overlays with no clear link to exposures. Banks should explain each overlay, its size and how it will be removed. See management overlays in ECL.

What do supervisors expect?

The ECB has expected banks it supervises to include climate and environmental risks in credit risk management, including collateral valuation and provisioning, since its 2020 guide. The EBA's Guidelines on the management of ESG risks, published in January 2025, apply from 11 January 2026, and from 11 January 2027 for small and non-complex institutions, and require banks to identify, measure and manage ESG risks over short, medium and long horizons. Supervisory expectations do not change IFRS 9, but they shape the evidence auditors expect. See auditing ECL.

Does this matter for non-banks?

For trade receivables measured with the simplified approach and a provision matrix, climate is rarely material because terms are short, but a company with customers concentrated in an exposed sector or region should consider it in its forward-looking adjustment. See forward-looking adjustments.

What should be disclosed?

IFRS 7 requires disclosure of how forward-looking information, including any climate assumptions, is incorporated, the inputs and assumptions used, significant changes, concentrations of credit risk and the effect of overlays. One of the IASB's 2025 illustrative examples shows credit risk disclosures for a lender exposed to climate-related risks. See ECL disclosures under IFRS 7.

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Questions people ask

How does climate risk affect expected credit losses?

Through higher probabilities of default, lower collateral values and higher loss given default, changes in drawdowns, and significant increases in credit risk that move loans to stage 2.

Is there a separate IFRS rule for climate risk in ECL?

No. IFRS 9 requires all reasonable and supportable forward-looking information, which includes material climate effects.

Can banks use overlays for climate risk?

Yes, where models cannot capture an effect, but overlays should be specific, quantified, governed, explained and replaced by model changes over time.

When did the EBA ESG risk guidelines start to apply?

From 11 January 2026, and from 11 January 2027 for small and non-complex institutions.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IFRS Foundation: IFRS 9 Financial Instruments
  2. IFRS Foundation: Effects of climate-related matters on financial statements, educational material, July 2023
  3. IFRS Foundation: near-final illustrative examples on climate-related and other uncertainties in the financial statements, July 2025
  4. Grant Thornton: IFRS Foundation issues illustrative examples on reporting uncertainties in the financial statements
  5. European Banking Authority: final Guidelines on the management of ESG risks, January 2025

Rules and fees change. If you are reading this long after October 11, 2026, confirm the figures with the source before you rely on them.

SustainabilityClimate risk in the financial statementsIFRS 9Expected credit losses under IFRS 9: the three stagesECLManagement overlays in ECL

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This guide is general information. It is not tax or legal advice for your situation.