Bank of England: the financial sector has “much more to do” to understand and manage climate risks

The Bank first announced its intention to introduce a mandatory and uniform stress testing regime for the sector in 2019 and delivery progressed to the original schedule despite Covid-19.

The Bank was finally able to launch the first series of “stress tests” in June 2021. The new direction confirmed that the stress tests will initially apply to 19 of the UK’s largest financial firms, in relation to the balance sheet at the end of 2020. These firms will be required to disclose climate-related risks to their portfolios on the axis of physical risk and transition risk, according to three scenarios.

The chosen scenarios were developed by the Network for Greening the Financial System (NGFS) and developed by the Bank of England. They do not cover any global climate policy action; early movement towards net-zero by 2050 at the latest and late action towards net-zero. Each scenario is accompanied by a projection over 30 years. In the best case, the increase in global temperature is capped at 1.8°C by 2050. In the worst case, the increase exceeds 3.3°C.

For each scenario, companies will need to quantify the potential risk in financial terms for managed assets and other liabilities. They will also be required to complete a qualitative questionnaire outlining senior management’s views on risk and their plans to reduce it. Companies must additionally state how their plans compare to those of similar competitors.

The Bank has this week published the results of this first series of tests.

The analysis revealed that most institutions in the financial sector are unable to predict potential climate-related losses. The tests focus on the TCFD’s “scenario analysis” approach, but warn that this process is “still in its infancy” and suffers from notable data gaps.

Sam Woods, Managing Director of the Prudential Regulation Authority, said: “Recent events such as the war in Ukraine and rising energy prices illustrate the challenges that banks and insurers may face due to changes in their operating environment. Today’s exercise explores how well they are equipped to manage the longer-term challenges of climate change, in the context of our goal of financial stability.

“We see that they are likely to be able to absorb the climate costs that fall on them without material risks to their solvency, but they will face significant headwinds and will therefore need to continue to invest in their ability to sustain the climate. transition of the economy to net zero.”

The analysis revealed that lack of data was a “recurring theme” throughout participant engagement. Other challenges and gaps that still need to be addressed include how organizations approach assessments and modeling to actually respond to climate risks.

Overall, the Bank of England notes that all organizations need to improve their climate risk management capabilities.

More positively, the analysis revealed that most UK banks and insurers are well placed to absorb the costs of the low carbon transition, but that these costs will be reduced if these institutions now focus on emissions reduction efforts.

The Bank of England says this exercise will inform the FPC’s approach to future policy issues.

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