The latest update on climate-related risks and the regulatory capital frameworks from the Bank of England

*The full BoE report can be viewed under the sources section  

Short term priorities

The Bank continues to stress the importance that regulatory capital frameworks adequately capture climate-related risks to ensure resilience of individual firms and the overall financial system. While further analysis is needed before any policy change occurs, the Bank reiterates some short-term priorities.

• Ensuring that capability gaps, i.e., the difficulties in identifying and measuring climate risks, are being worked on and addressed by firms is a short-term priority for the Bank.
• The Prudential Regulation Authority (PRA) expects firms to pursue their efforts on the implementation of regulatory expectations on effective climate risk management as defined in the Supervisory Statement SS3/19 and to report sufficient information on their analysis of climate risk and own capital adequacy assessment under ICAAP (banks) and ORSA (insurers).
• The PRA also plans to support efforts for consistent and comparable disclosure standards for climate risk, and to support high quality and consistent accounting practices.

Key findings from the Bank:

Finding 1: Existing capability and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses. This uncertainty represents a risk appetite challenge for micro and macroprudential regulators. Regulators, including the Bank, need to form judgements on whether quantified and unquantified risks are within its risk appetite – and act accordingly.

Finding 2: Effective risk-management controls within firms can reduce the quantum of capital required in the future for resilience, but the absence of controls might suggest a greater quantum of capital will be required. As a short-term priority, the Bank is focused on ensuring firms make progress to address ‘capability gaps’ to improve their identification, measurement, and management of climate risks.

Finding 3: The Bank has explored conceptual issues to better understand the nature and materiality of ‘regime gaps’ in the capital framework. The unique characteristics of climate risks mean that their capture by capital frameworks requires a more forward-looking approach than used for many other risks. Scenario analysis and stress testing will play a key role in this. Regulators, including the Bank, need to focus on the development of these frameworks and how they can inform capital requirements. Firms will be expected to make further progress in this regard.

Finding 4: Current evidence suggests that the existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks. Therefore, there does not appear to be sufficient justification for regulators, including the Bank, to make a policy change to these time horizons. The Bank will continue to explore how climate risks can be calibrated within the timelines embedded in existing capital frameworks.

Finding 5: Further work is needed to assess whether there may be a regime gap in the macroprudential framework. Any use of macroprudential tools would need to be assessed carefully against how well they mitigate climate risks, their behavioural impacts, and the potential for unintended consequences. Calibration of macroprudential tools would also be challenging given uncertainties around climate risks and the need for them to help facilitate an orderly transition to a net zero economy. The Bank will explore the nature and materiality of such regime gaps as part of its ongoing policy work and consider whether action to address them would be appropriate.

Finding 6: Research on the conceptual challenges of incorporating climate risks into the capital frameworks appears to be limited based on submissions to the Bank’s call for research papers. Further research and greater public dialogue would therefore be valuable, notably in sparsely covered areas listed within this report.

Further observations

The Bank has elaborated on the difference between banking and insurance capital frameworks in the context of climate change risks. In case of banks, the most pronounced impact from climate is on the assets’ value, while for insurers it is both the value of assets and liabilities. The banking and insurance capital frameworks consist of different policy tools to manage risks, and addressing capital framework regime gaps requires taking different approaches. The Bank will continue to engage with researchers, academics, and other regulators on potential adjustments to regulatory capital frameworks. 

Across the borders

The discussion on whether existing regulatory capital frameworks adequately capture climate risks takes place not only in the UK but continues in Europe, and other leading jurisdictions. It is generally agreed that climate risks that are not adequately captured within the existing Pillar 1 framework should be considered and properly analysed by banks under Pillar 2. The current understanding of how climate risks may be captured in the existing Pillar 1 framework has been summarised by the Basel Committee on Banking Supervision in its publication from December 2022. Further research on the systemic nature of climate risks and the potential adjustments to macroprudential frameworks continues internationally. With regards to insurers, the existing Solvency II framework is assumed flexible enough to capture climate risks, but further evidence is being gathered.

Financial firms should continue monitoring the latest developments in regulatory capital frameworks and make sure they meet regulatory expectations with regards to climate risk management, including the identification and analysis of material climate risks that are part of their capital adequacy assessment.

1. Bank of England report on climate-related risks and the regulatory capital frameworks | Bank of England
2. Frequently asked questions on climate-related financial risks (bis.org)