Bank of England: Finance 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 test regime for the sector back in 2019 and the delivery has progressed to the original timeline in spite of Covid-19.

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

The chosen scenarios have been developed by the Network for Greening the Financial System (NGFS) and built upon by the Bank of England. They cover no policy action on climate globally; early movement towards net-zero by 2050 at the latest and late action towards net-zero. Each scenario comes with a 30-year projection. In the best-case scenario, the global temperature increase is capped to 1.8C by 2050. In the worst-case scenario, the increase exceeds 3.3C.

For each scenario, firms will need to quantify potential risk in financial terms across both managed assets and other liabilities. They will also need to complete a qualitative questionnaire outlining senior executives’ own views on the risks and their plans for reducing them. Firms should additionally outline how their plans stack up against those of similar competitors.

The Bank has this week published the findings from this first round of tests.

The analysis found that most institutions in the finance sector are unable to project 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 suffered from notable data gaps.

The Prudential Regulation Authority’s chief executive Sam Woods commented: “Recent events such as the war in Ukraine and rises in energy prices illustrate the challenges banks and insurers can face from changes in their operating environment. Today’s exercise explores how well they are equipped to manage the longer-term challenges from climate change, in the context of our financial stability objective.

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

The analysis found that a lack of data was a “recurrent theme” across participant involvement. Other challenges and gaps that still need to be addressed include how organisations approach the assessments and modelling to actually respond to climate risks.

Across the board, the Bank of England notes that all organisations need to improve their climate risk management capabilities.

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

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