The Bank of England shares useful insights to measure climate-related financial risks using scenario analysis

The article focuses on climate as a financial risk from a system-wide risk perspective and with regards to the BoE’s own financial operations. While not a supervisory guidance, the article explores how central banks and financial institutions can use scenario analysis to quantify these risks.

It is therefore advisable for regulated firms to understand the key messages of this article and assess where they can incorporate these in their own thinking around quantifying climate risks as a part of their stress testing and ongoing operations.

Below we discuss some key observations from the paper.

The BoE’s approach to scenario analysis

The paper focuses on the BoE's approach for using scenario analysis to measure climate-related financial risks, including [1]:  

• Selecting, designing, and analysing scenarios to measure climate-related financial risks.
• Applying macro scenario analysis to sovereign bonds with a focus on debt-to-gross domestic product (GDP) component modelling.
• Applying macro scenario analysis to corporate bonds.
• Applying physical risk and transition risk scenario analysis to residential mortgages.
• How scenario analysis outputs can be applied to financial institutions’ existing financial modelling toolkits.

The BoE emphasised the importance of selecting, adjusting and designing climate-related scenarios which are relevant to its objectives from the exercise. It notes that commonly used scenarios from renowned providers such as the Network for Greening the Financial System (NGFS) or the Intergovernmental Panel on Climate Change (IPCC) may not capture the full suite of potential climate risks, and may not be calibrated accurately to incorporate ongoing climate-related research. As such, the BoE selected the more severe scenarios from the NGFS and the IPCC.

It also gives insightful views on the need to extend macro-climate scenarios from the country or regional level to the asset level given the idiosyncratic nature of climate risks.

Conducting asset-specific scenario analysis

The BoE shared ideas and approaches to apply macro scenario analysis to three asset classes: sovereign bonds, corporate bonds, and residential mortgages, noting these are widely present in the UK market and/or important instruments for the BoE’s own asset portfolio.

• Sovereign bonds: understanding the bond yield drivers is crucial to apply relevant climate-related shocks. These drivers comprise expected policy rates, sovereign credit risk premia and other risk premia, the first two being directly affected by physical and transition climate risks. The steps consist of projecting interest rates over a 30-year period per sovereign, and then understanding how debt-to-GDP ratios and sovereign credit ratings change over a climate scenario using a random forest machine learning model relying on seven debt and GDP components. The results highlight that the largest increases in credit risks were observed in business-as-usual scenarios with large physical risks, while more orderly transitions are associated with lower levels of credit risk.
• Corporate bonds: extending NGFS climate scenarios to corporate bond-level is necessary to capture idiosyncratic features of these assets. Four components act as anchor points for the analysis:
  • Impact of carbon pricing on specific issuer.
  • Impact of other transition risks and opportunities on specific issuer.
  • Impact of physical risks on specific issuer.
  • Interdependencies across the whole supply chain.

Once the scenario expansion exercise has been conducted, firms can leverage their existing financial models such as discounted cash flows to estimate impacts on financial asset valuation. The BoE’s own results emphasised the idiosyncratic nature of climate risk impacts within a sector, reinforcing the idea that firms should expand macro climate scenarios to the asset level to truly capture the financial implications.

• Residential mortgages: long-term maturities of 25 to 40 years mean that climate risks may crystallise in several decades time. On the transition risk side, linking energy efficiency from energy performance certificates (EPC) to price shocks is necessary to measure the impact on households’ debt-servicing ratios. On the physical risk side, isolating weather events and hazards like flooding relevant to specific properties or areas will help to assess the impact of climate scenarios on the market value of mortgage books.

The BoE’s results demonstrate the correlation between EPC, annual energy cost increases and debt-servicing ratio increases. Incorporating insurance premia and claims makes a difference in the fall of house prices.

What it means for UK financial institutions

Financial institutions should understand and consider the BoE’s own approach for measuring climate-related financial risks using scenario analysis, as this provides an insightful view into some of the rationales of its supervisory expectations in this regard. 

This paper’s findings also resonate with recent publications from the European Central Bank (ECB) and the European Banking Authority which touched upon climate-related data, scenarios and models as it reinforces the use of climate scenario analysis to quantify outputs then incorporated into traditional financial risk models. You can learn more about this in our global blog.

The BoE is expecting firms to continue strengthening their climate risk frameworks including their scenario analysis capabilities. It has also announced that it will update its supervisory statement SS3/19 on climate risks in 2024. This refresh will constitute more binding expectations for regulated firms in the UK.

The field of climate financial risk management has evolved rapidly since the publication of the original supervisory statement so firms will be waiting eagerly to see how the BoE’s expectations have changed. What is clear is that, as time moves on and climate financial risk management best practices become commonplace, supervisory authorities are likely to expect firms to have resolved their implementation challenges.

For instance, the ECB announced it would be moving to the next levels of its escalation mechanisms, and that it would ultimately issue periodical fines to supervised financial institutions which do not comply with its climate risk expectation by end of 2024. While we do not expect the BoE to undertake such an approach in the near future, this demonstrates how the topic is rapidly rising in the list of priorities of the supervisors. 

Notes

1. The BoE’s own consideration of climate risks flows directly from its primary monetary and financial stability objectives. To achieve its financial and monetary stability objectives the BoE undertakes financial operations, including collateralised credit operations, repurchase agreements and asset purchases. The BoE also undertakes market operations as part of funding its activities and managing its own foreign currency reserves. As part of its financial risk management framework, the BoE considers a range of risks to ensure it has the resources available to achieve its primary objectives. Climate risks are one of the risks the BoE considers, as set out in the BoE’s 2023 Climate Disclosure.