Banking Law and Physical Climate Risk Financing in Spain

1. Introduction

Physical climate risk financing concerns the financing, management and mitigation of financial losses arising from the physical effects of climate change.

For Spanish banks, this includes risks arising from:

• floods;
• drought;
• wildfires;
• extreme heat;
• storms;
• coastal erosion;
• water scarcity; and
• other climate-related physical events.

The subject is increasingly important because climate events can affect both borrowers' ability to repay loans and the value of assets offered as collateral.

A simplified chain is:

Climate event → physical damage → borrower income/assets affected → loan repayment capacity falls → collateral value may fall → bank credit risk increases.

Spanish banking law therefore increasingly treats climate risk as part of broader credit, market, operational and governance risk.

2. No Standalone “Physical Climate Risk Financing Law”

Spain does not have one statute called the “Physical Climate Risk Financing Act.”

Instead, the framework comes from several interacting areas:

• Spanish banking and prudential law;
• EU banking regulation;
• climate-change legislation;
• environmental and taxonomy rules;
• mortgage and real-estate law;
• insurance and catastrophe-risk arrangements;
• disclosure requirements; and
• supervisory expectations.

The main Spanish climate statute is Law 7/2021 of 20 May on Climate Change and Energy Transition.

At the banking level, important EU rules include the Capital Requirements Regulation (CRR), Capital Requirements Directive (CRD), EBA climate-risk requirements, the EU Taxonomy Regulation, and the Corporate Sustainability Reporting Directive (CSRD) for entities within its scope.

3. Meaning of Physical Climate Risk

Physical climate risk is normally divided into two categories.

Acute physical risk

These are sudden events such as:

• floods;
• wildfires;
• storms;
• extreme rainfall;
• heatwaves; and
• drought episodes.

Chronic physical risk

These develop over longer periods, such as:

• rising temperatures;
• long-term water scarcity;
• sea-level rise;
• desertification; and
• gradual coastal erosion.

For a bank, both categories can affect the probability that a borrower will default.

4. Spain's Particular Exposure

Spain has geographically diverse climate risks.

Different regions may face different exposures to:

• water scarcity;
• drought;
• extreme heat;
• flooding;
• wildfire;
• coastal risks; and
• agricultural losses.

Therefore, a bank cannot adequately assess physical climate risk solely at national level.

A loan secured by coastal property has a different risk profile from a loan secured by an inland industrial facility.

Likewise:

agricultural borrower in a drought-exposed region

and

software company in an urban office

may have very different physical climate-risk exposures.

5. Law 7/2021

Law 7/2021 on Climate Change and Energy Transition establishes Spain's national framework for climate mitigation and adaptation.

Its significance for finance includes the recognition that climate change creates economic and financial risks requiring integration into public policy and economic decision-making.

The legislation also establishes mechanisms concerning:

• climate neutrality;
• adaptation;
• energy transition;
• financial-system considerations; and
• climate-related reporting and assessment.

For banks, this forms part of the wider legal environment in which climate risks are incorporated into financial decision-making.

6. Banco de España and Climate Risk

The Banco de España increasingly treats climate-related financial risks as part of financial stability and prudential supervision.

Physical climate risk can affect:

Credit risk

Borrowers may lose income following climate damage.

Collateral risk

Property or equipment securing a loan may lose value.

Market risk

Climate events can affect securities and investment portfolios.

Operational risk

Bank branches, data centres or infrastructure can be damaged.

Insurance risk

Insurance costs or availability can change following repeated climate events.

The bank therefore needs a framework capable of identifying and measuring these channels.

7. ECB Climate Supervisory Expectations

For significant Spanish banks subject to the Single Supervisory Mechanism (SSM), ECB climate-related supervisory expectations are particularly important.

The ECB has expected banks to incorporate climate and environmental risks into:

• governance;
• business strategy;
• risk management;
• credit risk;
• stress testing;
• disclosure; and
• risk appetite.

Physical climate risk should therefore be considered within ordinary prudential processes rather than treated merely as a corporate-social-responsibility issue.

8. Physical Climate Risk and Credit Risk

Consider a Spanish agricultural company that borrows €20 million.

Its repayment depends upon agricultural production.

A prolonged drought could cause:

lower production → lower revenue → weaker cash flow → increased probability of default.

The bank therefore needs to consider climate exposure when assessing the borrower's creditworthiness.

This does not mean the bank must automatically reject climate-exposed borrowers.

Instead, the risk can be incorporated into:

• pricing;
• maturity;
• collateral requirements;
• covenants;
• insurance requirements; and
• monitoring.

9. Mortgage Lending

Physical climate risk is particularly relevant to mortgage finance.

Suppose a bank holds a €300,000 mortgage secured by a property in a flood-prone area.

A severe flood could cause:

• structural damage;
• reduced property value;
• insurance complications;
• temporary loss of habitability; and
• borrower income disruption.

The bank therefore faces both:

borrower credit risk

and

collateral risk.

10. Property Valuation

Traditional mortgage valuation focuses on factors such as:

• location;
• building condition;
• market prices;
• income potential; and
• comparable transactions.

Climate risk adds another variable.

A prudent valuation may need to consider:

• flood exposure;
• wildfire exposure;
• coastal exposure;
• heat;
• water availability;
• adaptation measures; and
• insurance availability.

The legal challenge is avoiding unsupported assumptions.

A property should not be given a lower value merely because it is located in a broad “climate-risk region.” The assessment should use credible physical-risk data.

11. Climate Risk and Loan Pricing

Physical climate risk can theoretically affect the cost of credit.

For example:

higher expected physical losses → higher expected credit risk → potentially higher risk-adjusted financing cost.

However, pricing should remain consistent with applicable consumer-protection, anti-discrimination and transparency requirements.

For retail borrowers, a bank cannot simply impose unexplained climate-related charges.

The basis of material pricing terms should be legally and contractually supportable.

12. Climate-Adaptation Financing

An important development is financing projects designed to reduce physical climate risk.

Examples include:

• flood barriers;
• water-efficiency infrastructure;
• drought-resistant agricultural systems;
• wildfire prevention;
• improved drainage;
• cooling systems;
• resilient buildings;
• water recycling;
• desalination infrastructure; and
• coastal protection.

This can be called adaptation finance.

It differs from financing renewable-energy projects, which are primarily associated with climate mitigation.

13. Green Loans for Adaptation

A Spanish bank may finance a project specifically designed to reduce physical climate exposure.

For example:

Bank → €50 million adaptation facility → agricultural water-efficiency project.

The financing terms can potentially be linked to measurable performance indicators such as:

• water consumption reduction;
• flood protection capacity;
• hectares protected;
• energy efficiency; or
• resilience improvements.

The precise classification of the financing under EU sustainable-finance rules depends upon the applicable criteria.

14. EU Taxonomy

The EU Taxonomy Regulation (Regulation (EU) 2020/852) is important for climate-related financing.

It establishes a framework for identifying environmentally sustainable economic activities.

One of its environmental objectives is:

adaptation to climate change.

For an activity to qualify under the Taxonomy framework, detailed technical screening criteria must be considered.

Therefore:

“climate-related” ≠ automatically “Taxonomy-aligned.”

Banks must apply the relevant technical criteria rather than simply attaching a green label to a loan.

15. Do-No-Significant-Harm Principle

Taxonomy analysis also incorporates the Do No Significant Harm (DNSH) principle.

An adaptation project should not simply solve one climate problem while creating another significant environmental problem.

For example, a project claiming climate-adaptation benefits may still need to consider its effects on:

• water;
• biodiversity;
• pollution;
• circular economy; and
• other environmental objectives.

This makes sustainable-finance classification a detailed legal and technical exercise.

16. Climate Stress Testing

Banks increasingly use climate scenarios to evaluate future financial resilience.

A simplified scenario could be:

Scenario A

Moderate climate change.

Scenario B

Severe drought.

Scenario C

Severe flood and wildfire exposure.

The bank then estimates potential effects on:

• defaults;
• collateral;
• capital;
• liquidity; and
• profitability.

Climate stress testing is not a prediction of what will happen. It is a tool for examining vulnerabilities under specified scenarios.

17. Scenario Analysis

A bank could assess a portfolio geographically.

For example:

This allows banks to identify concentrations.

18. Insurance and Climate Risk

Insurance can substantially affect bank exposure.

A mortgage property may be insured against certain risks, but coverage may have:

• exclusions;
• limits;
• deductibles;
• conditions;
• renewal risk; or
• affordability problems.

Repeated climate events can also change the economics of insurance.

Therefore:

collateral value + insurance availability

should be considered together.

19. Spanish Natural Catastrophe System

Spain has a distinctive mechanism involving the Consorcio de Compensación de Seguros (CCS).

The CCS plays an important role in compensating certain extraordinary risks under the Spanish insurance system.

This matters for banking because catastrophe-related insurance arrangements can influence the extent to which physical damage translates into uninsured borrower losses.

The precise availability of compensation depends upon:

• the insurance contract;
• the nature of the event;
• applicable statutory conditions; and
• the relevant CCS rules.

A bank should therefore not assume that every climate-related loss is automatically covered.

20. Climate Risk and Agricultural Lending

Agricultural finance is particularly exposed to physical climate risk.

Drought can affect:

• crop yields;
• livestock;
• irrigation;
• commodity prices;
• borrower cash flow; and
• repayment capacity.

Banks can respond through structures such as:

• seasonal repayment;
• grace periods;
• insurance-linked lending;
• diversified collateral;
• sustainability-linked facilities; and
• restructuring mechanisms following qualifying shocks.

21. Infrastructure Financing

Physical climate risks are also relevant to infrastructure loans.

Consider a financing facility for a Spanish transport project.

Extreme rainfall could damage:

• roads;
• bridges;
• rail infrastructure;
• drainage systems.

The bank should therefore examine whether the project's design incorporates appropriate resilience.

Climate-resilience analysis can become part of ordinary project-finance due diligence.

22. Corporate Lending

For large corporate borrowers, physical climate risk can affect:

• factories;
• warehouses;
• supply chains;
• raw materials;
• transport;
• labour productivity; and
• insurance.

The bank should consider both direct and indirect exposure.

For example:

Borrower's factory unaffected → supplier's factory flooded → production interrupted → borrower revenue falls.

Thus, physical climate risk can travel through supply chains.

23. Climate Risk Covenants

Loan agreements can potentially contain climate-related covenants.

Examples include requirements to:

• maintain specified insurance;
• maintain flood-protection measures;
• comply with adaptation plans;
• report material climate-related damage;
• maintain critical infrastructure;
• disclose major environmental events; or
• meet agreed resilience milestones.

These clauses should be drafted carefully so that they are objectively measurable.

24. Climate-Linked Financing

A sustainability-linked loan can link financial terms to specified sustainability performance targets.

For example:

interest margin adjustment → achievement of agreed water-efficiency target.

This is different from a conventional green loan.

A green loan is generally linked to the use of proceeds for eligible projects, whereas a sustainability-linked structure focuses on performance against defined targets.

The legal documentation must accurately describe the product.

25. Greenwashing Risk

Climate-related financing creates an important legal risk: greenwashing.

A bank should not describe a loan as “climate-resilient,” “green” or “sustainable” without sufficient evidence.

Potentially relevant issues include:

• misleading marketing;
• inaccurate sustainability disclosures;
• failure to satisfy Taxonomy criteria; and
• inconsistency between public statements and actual financing.

Banks therefore need reliable documentation supporting environmental claims.

26. Disclosure

EU sustainability disclosure requirements increasingly require financial institutions and companies within scope to report relevant information concerning sustainability risks and impacts.

For banks, disclosure can concern:

• climate exposure;
• financed activities;
• risk management;
• Taxonomy alignment; and
• sustainability indicators.

The purpose is to give investors and other stakeholders more comparable information.

27. Climate Risk and Capital

Climate risk can ultimately affect prudential capital through its effect on ordinary banking risks.

For example:

flood → borrower loss → probability of default rises → expected credit loss rises → bank's financial position deteriorates.

The regulatory framework does not necessarily create a separate “climate capital ratio.”

Instead, climate-related factors increasingly feed into conventional prudential risk categories.

28. Governance Responsibilities

Bank boards have an important role in climate-risk management.

Governance should consider:

• climate-risk appetite;
• portfolio concentrations;
• scenario analysis;
• risk policies;
• data quality;
• disclosure;
• adaptation strategy; and
• senior-management responsibility.

The board does not need to predict every future climate event.

It needs to ensure that material foreseeable risks are appropriately identified and managed.

29. Data Problems

Physical climate risk is difficult to quantify.

Banks may need:

• geographical information;
• flood maps;
• wildfire maps;
• drought projections;
• property-level information;
• insurance information; and
• borrower-level financial data.

Data can be incomplete or based on uncertain future scenarios.

Consequently, banks should document assumptions and limitations rather than present climate-risk estimates as exact predictions.

30. DORA and Physical Climate Events

The EU's Digital Operational Resilience Act (DORA) is also relevant indirectly.

A climate event can cause:

• data-centre failure;
• telecommunications disruption;
• branch closure;
• electricity interruption; or
• third-party service failure.

Banks therefore need operational-resilience arrangements capable of functioning during physical disruptions.

Climate resilience and digital resilience can overlap.

Case Law

A critical point should be made at the outset:

There is very little reported Spanish or EU case law directly deciding “physical climate risk financing by banks.”

Most climate litigation concerns environmental regulation, state duties, emissions, human rights or public authorities rather than the prudential treatment of climate risk in individual bank loans.

Accordingly, the following cases are relevant comparative authorities, not direct precedents establishing a Spanish bank's climate-financing obligations.

31. ECtHR — Verein KlimaSeniorinnen Schweiz and Others v Switzerland, Application No. 53600/20, Grand Chamber, 9 April 2024

The European Court of Human Rights found Switzerland had failed to comply with its positive obligations under Article 8 in relation to climate change and also found an Article 6 issue concerning the association's access to court.

Relevance to banking

The judgment demonstrates that climate change can create legally significant risks to individuals' rights.

For financial institutions, the broader implication is that climate change is increasingly treated as a legally material risk rather than purely an environmental policy issue.

It does not, however, establish a direct duty on Spanish banks to provide climate finance.

32. ECtHR — Duarte Agostinho and Others v Portugal and 32 Others, Application No. 39371/20, Grand Chamber, 9 April 2024

The applicants sought to hold multiple European states responsible for climate-related human-rights harms.

The Court declared the application inadmissible on jurisdictional and procedural grounds.

Relevance

The case demonstrates the limits of climate litigation as well as its potential scope.

For Spanish banking law, it reinforces the need to distinguish:

state climate obligations

from

private financial institutions' regulatory obligations.

33. CJEU — Aristoteleio Panepistimio Thessalonikis, Case C-461/13

The CJEU addressed environmental-law obligations involving water and environmental assessment.

Banking relevance

Water availability is an important physical climate risk for Spanish agricultural and industrial borrowers.

Environmental authorization and water-law compliance can therefore affect the viability of projects financed by banks.

The case is not a banking case, but it illustrates why environmental authorization can become part of credit due diligence.

34. CJEU — Waddenzee, Case C-127/02

The CJEU developed an important precautionary approach under EU environmental law.

Projects potentially affecting protected areas must be evaluated carefully before authorization.

Banking relevance

A bank financing climate-adaptation or infrastructure projects must consider whether environmental approvals are required and whether environmental litigation could delay the project.

A project that cannot lawfully proceed may have significantly lower credit value.

35. CJEU — People Over Wind and Sweetman, Case C-323/17

The Court examined the treatment of mitigation measures in environmental assessment.

Banking relevance

Infrastructure and renewable/adaptation projects financed by banks may depend on environmental assessments and mitigation measures.

The legal status of those measures can affect:

• project approval;
• construction schedules;
• financing conditions; and
• projected cash flow.

36. Spanish Constitutional Court — Water and Environmental Jurisprudence

The Spanish Constitutional Court has issued important decisions concerning Spain's division of powers and regulation of water and environmental resources.

These cases are relevant to physical climate-risk finance because water scarcity is an increasingly important financial risk.

However, they should not be mischaracterized as cases establishing direct climate-risk duties for Spanish banks.

Their relevance is primarily that environmental and water regulation can materially affect the legality and economic viability of financed projects.

37. How Case Law Affects Bank Financing

The cases above show several principles relevant to lending.

Principle 1: Environmental legality matters

A project cannot be treated as financially viable if necessary environmental approvals are absent.

Principle 2: Climate risk has legal dimensions

Climate change can generate rights-based and regulatory consequences.

Principle 3: Environmental litigation can create financial risk

Court proceedings may delay or restrict projects.

Principle 4: Climate litigation does not automatically create bank liability

The legal responsibility of governments and private financial institutions must be analyzed separately.

38. Example: Flood-Exposed Mortgage Portfolio

Suppose a Spanish bank has:

€2 billion of residential mortgages

in areas exposed to significant flood risk.

A physical-risk assessment could examine:

1. property location;
2. flood probability;
3. building characteristics;
4. insurance coverage;
5. mortgage-to-value ratio;
6. borrower income;
7. adaptation measures; and
8. potential property-value changes.

The bank could then estimate portfolio sensitivity under different scenarios.

The result should feed into risk management rather than automatically producing cancellation of existing loans.

39. Example: Drought-Exposed Agricultural Finance

Suppose a bank finances €100 million of agricultural businesses.

A drought scenario produces:

water shortage → crop losses → lower revenue → weaker borrower cash flow → increased defaults.

The bank might respond through:

• more detailed monitoring;
• seasonal repayment structures;
• insurance requirements;
• adaptation financing;
• diversified collateral; or
• restructuring where legally appropriate.

The purpose is risk management, not punishment of climate-exposed borrowers.

40. Physical Risk and Sustainable Finance

Physical-risk finance therefore has two sides:

Defensive

Banks identify and manage climate-related losses.

Constructive

Banks finance measures that reduce those losses.

The second category includes:

• resilient buildings;
• water infrastructure;
• wildfire prevention;
• agricultural adaptation;
• flood protection;
• cooling infrastructure; and
• climate-resilient transport.

41. Key Legal and Regulatory Risks

42. Practical Spanish Banking Framework

A Spanish bank assessing physical climate risk can use this sequence:

Identify physical hazard
↓
Map borrower/property exposure
↓
Assess vulnerability
↓
Estimate financial impact
↓
Assess insurance/adaptation
↓
Adjust credit-risk assessment
↓
Stress-test portfolio
↓
Monitor exposure
↓
Report/disclose where required

This integrates climate risk into normal banking processes.

43. Difference Between Physical and Transition Risk

This distinction is essential.

Physical risk

Climate itself causes damage.

Example:

Flood damages a warehouse.

Transition risk

The economic transition away from high-carbon activities causes financial effects.

Example:

New emissions regulation makes a carbon-intensive industrial plant more expensive to operate.

A Spanish bank should analyze both, but they are legally and economically distinct.

44. Conclusion

Physical climate risk financing in Spain is an emerging component of banking and prudential law rather than a separate statutory banking product.

The legal framework combines Law 7/2021 on Climate Change and Energy Transition, EU prudential requirements, ECB/SSM supervisory expectations, EBA requirements, the EU Taxonomy Regulation, sustainability-disclosure rules, insurance law and ordinary Spanish banking and contract law.

Physical risks such as floods, drought, wildfires, extreme heat, water scarcity and coastal impacts can affect banks through borrower defaults, declining collateral values, operational disruption, insurance problems and supply-chain failures. Consequently, banks increasingly incorporate these risks into credit assessment, governance, stress testing, valuation and portfolio management.

At the same time, banks can finance climate-adaptation projects, including flood protection, water-efficiency infrastructure, resilient buildings and wildfire-prevention measures. Such financing must satisfy the applicable EU sustainable-finance criteria before being described as Taxonomy-aligned or otherwise environmentally sustainable.

The case-law position requires particular care. There is presently no substantial body of Spanish reported jurisprudence directly determining how a bank must price or lend against physical climate risk. The most relevant European climate cases—Verein KlimaSeniorinnen v Switzerland*, Duarte Agostinho, Waddenzee, and *People Over Wind—concern climate rights and environmental regulation rather than direct bank lending obligations. They nevertheless demonstrate why climate impacts, environmental approvals and physical hazards can become legally material to projects financed by banks.

The central banking principle is:

Physical climate risk should be incorporated into ordinary financial-risk management according to credible evidence and proportionate methodologies, while climate-adaptation financing can be used to reduce the underlying risk rather than merely pricing it after the damage occurs.