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The Bank of England (BoE) has told financial institutions that unless they step up their work to deal with the burgeoning climate crisis, climate risks could trigger a “persistent and material drag on their profitability”.
The warning comes as the central bank publishes the results of its Climate Biennial Exploratory Scenario. Launched last year, the supervisory stress test explores the financial risks posed by climate change for the largest UK banks and insurers.
Although loss projections vary across participants and scenarios, the Bank of England has said that they are equivalent to an annual drag on profits of around 10-15 percent on average.
Losses of this magnitude could make individual firms, and the financial system overall, more vulnerable to other future shocks.
“Climate change is now firmly in the focus of prudential regulators across the globe,” said the Bank of England’s Sam Woods, in a speech that coincided with the release of the report.
“Tackling the threat from climate change will involve efforts by governments across the globe, as well as by many other organisations and individuals.”
The Bank of England’s stress testing found that there is a need among the UK’s largest institutions for more data on and understanding of customers’ current emissions and transition plans.
This includes looking through complex chains of financial relationships between clients and counterparties to see the underlying emissions.
Institutions are also advised about the need to invest in modelling capabilities and do more to scrutinise data and projections supplied by third parties.
Meanwhile, the BoE has suggested that there is a need for some firms to consider more deeply how they would respond strategically to different scenarios, including thinking through the implications of different paths for climate policy.
“Transitioning to net zero will be a major challenge for our institutions and societies even in a benign economic environment, doing so without confidence in the basic functioning of the financial system would be near impossible,” said Woods.
It is, therefore, vital that firms can withstand risks to their safety and soundness, including those that arise as a consequence of climate change. In particular, he cautioned against “both physical risks like flooding and extreme weather events, and ‘transition’ risks that arise as the economy moves away from carbon-intensive activities”.
In spite of the recommendations that the central bank has set out, the findings did show that institutions will be able to withstand the shocks that will come with climate change.
At an aggregate level, UK banks and insurers are likely to be able to absorb the costs of transition that fall on them, the BoE has concluded.
The overall costs will be lowest with early and well-managed action to reduce greenhouse gas emissions and so limit climate change. However, it also pointed out that costs that initially fall on banks and insurers will ultimately be passed on to their customers.
Learning lessons
The Bank of England pointed out that projections of climate losses are uncertain. Scenario analysis in this area is still in its infancy and there are several notable data gaps.
Although UK banks and insurers have made progress, more work is needed to understand and manage their exposure to climate risks.
Going forward, the central bank has said it will work closely with firms to improve climate risk capabilities.
The firm-specific findings of the exercise, for example, will inform ongoing dialogue about the management of climate risks between participating firms and their supervisors. Evidence gathered from the stress test could reveal where more intensive action is needed by firms to address the issues identified.
However, the BoE also acknowledged that this was its first detailed climate exercise involving both banks and insurers. There are several lessons learned in this process that can be applied for the appropriate design and execution of future climate stress scenarios and exercises.
For example, allowing participants to exercise flexibility rather than being prescriptive in approaches to modelling and asking them to liaise directly on climate risks with their counterparties has driven improvements in banks’ and insurers’ risk management approaches. It has helped expose data and modelling gaps.
The BoE also said that it had also learnt that participants found it difficult to consider their responses to the stress test scenarios in-depth, in part reflecting uncertainty about aspects of climate policy.
This uncertainty meant participants had to make assumptions about the precise form such policy would take.
