Are Banks Prepared for Climate Change? Greg Readings

At the end of 2020 we highlighted (Stressed About Climate Change) that the Bank of England (BoE) was planning to carry out an ‘exploratory scenario exercise’ on climate risk, referred to as the Climate Biennial Exploratory Scenario (CBES). The aim was to consider the resilience of the major UK banks, insurers, and wider financial system to physical and transition risks from climate change, size-up the system’s exposure to climate-related risks and assist participants in enhancing their management of climate‑related financial risks.

The results of the CBES have been published, so what do they tell us?

CBES used three scenarios – which the BoE is keen to point out are not forecasts – exploring the transition and physical risks of climate change over the next 30 years: ‘early action’ and ‘late action’ transitions to net-zero UK greenhouse gas emissions by 2050, and ‘no additional action’ in terms of policy responses to global warming.

Under all three scenarios, the impacts of climate change are likely to become a drag on the profitability of banks and insurers and the projections suggest that if the firms do not respond effectively, this drag may become persistent and material. Estimates of the potential losses are vary widely across the exercise but point towards an average 10-15% annual drag on profits. Perhaps unsurprisingly, early, well-managed action to reduce greenhouse gas emissions and so limit climate change is the least costly scenario.

Although the scale of these potential losses is significant, the BoE currently judges that the costs of the transition to net zero look to be absorbable for banks and insurers without a worrying impact on their solvency. However, there is a huge amount of uncertainty in the projections and such losses could also make the individual companies, and the wider financial system, more vulnerable to other future shocks. At this stage the BoE doesn’t think there’s a clear-cut case for a change in regulatory capital requirements for the firms, but the CBES has raised a number of important questions in this area for the regulator to ponder.

One of the reasons that the banks should be able to deal with the costs associated with climate risks is that a significant portion may eventually be passed on to their customers. This was particularly the case in the ‘no additional action’ scenario, where businesses and households vulnerable to the physical risks of climate change could be hit hard. For example, homes at risk of flooding would probably become very expensive – or indeed impossible - to insure or borrow against.

The speed and scope of the climate transition across the global economy will be significantly influenced by the actions of governments, given they set public climate policy. Another main point expressed by the report is that banks and insurers have a collective interest in managing their climate-related financial risks in a way that supports the transition – but they will need to improve climate risk management in order to do so.

When it comes to banks and climate change, their amount of lending to the fossil fuel industry often makes headlines. While the CBES report sets out that it will be in banks’ interests to lend to companies with credible net zero transition plans and reduce exposure to sectors that are inconsistent with a net zero policy, the BoE suggests that banks will need to continue to provide finance to carbon-intensive sectors to allow them to invest in the transition. Indeed, “cutting off finance to these corporates too quickly could prove counterproductive” according to the head of the BoE’s Prudential Regulation Authority.

As for how the UK banks are doing with regards to managing climate risks, the BoE sees this as a ‘good news story’, being encouraged by the progress the firms have made in some areas. They are keen to point out, though, that there is still much more for the banks to do to understand and manage their climate risks exposure.

The BoE will give firm-specific feedback to participants (the results have been published on an overall basis and not broken down by individual banks/insurers) but has noted a couple of key themes

  • A lack of data on factors that the banks need to understand to manage climate risks – including customers’ current emissions and transition plans
  • The range in the quality of different approaches taken across the banks and insurers to the assessment and modelling of climate risks

This relates back to there being much more work to do in this area and suggests some banks are doing better than others, without revealing which. It’s emphasised that that uncertainty around the impact of climate change remains extremely high given scenario analysis is still in its infancy and there are several notable data gaps. However, the BoE highlights that the CBES has already helped drive improvements in these areas.

The BoE has stated it will continue to work on this important topic, which will include working further with banks and insurers to improve climate risk management by disseminating best practice and supporting initiatives to help fill data gaps.

Within the BoE itself, the CBES findings will help inform thinking around system-wide policy issues related to climate risk as well as regulatory supervisory policy and approach. Key lessons will also be shared with the UK Government and other central banks, helping to advance global thinking on how to manage climate-related financial risks.

While the CBES seems to have garnered little fanfare, the BoE sees it as an important step forward and one which will continue to be built on in order to protect and enhance the stability of the UK’s financial system and help ensure it can support the transition to a net-zero economy.

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