Climate and sustainability - Q2 2022

Banks and insurers should continue to develop their approach to refine, innovate, and integrate climate-related financial risk management practices, as the understanding of the risks, data, tools, and best practices progress. 

Firms must ensure they have comprehensively embedded the management of climate-related financial risks into their existing risk management frameworks alongside their 2021/22 ICAAP or own risk and/or solvency assessment (ORSA), in a manner that is proportionate to their size, the complexity of their business, and the extent of the climate-related financial risks that they face.

Banks and insurers should keep aware of results from a planned research conference on capital requirements and climate-related risk on October 19, 2022, and any other statements about potential changes to capital frameworks to better capture climate-related financial risks on the horizon.

Companies should also remain aware of the results of the 2022 Climate Biennial Exploratory Scenario (CBES) as part of their regulatory horizon scanning. The results will help inform the PRA’s supervisory priorities and approach to supervisory policy in relation to financial risks from climate change.

Our advice to banks is to perform an internal review of Climate Change readiness towards the end of this year.

Climate Biennial Exploratory Scenario (CBES)

Alongside the release of the first CBES results, Sam Woods, Chief Executive Officer of the Prudential Regulation Authority (PRA) delivered a speech where he set out his vision on how climate risk fits within the PRA’s mission.

This extract clarifies how some elements of Sam Woods’ message could be interpreted by regulated firms.

Role of prudential policy, What impact climate risks can have on capital requirements?

Whilst citing the role of the PRA to ensure the safety and soundness of banks and safeguarding the interests of insurance policyholders, he mentioned that it is getting this core job right that will help the economy achieve the net zero emission target.

Perhaps as expected, Sam Woods stressed how Boards and individuals who hold top management positions need to seize the seriousness of the situation and develop a clear and comprehensive understanding of what financial impact climate change can have on their balance sheets and business models.

What management should consider:

• Is there clarity on the P&L and Balance Sheet (financial) and operational (non-financial) impacts of the most likely climate catastrophes on firms’ most material exposures?

• Is there adequate senior management accountability on quantification and response to this impact?

What impact climate risks can have on capital requirements?

The case for holding capital to absorb the financial and non-financial impacts of climate catastrophes is clear – that it can address the consequences of climate change by building resilience and diverting capital. However, Sam was clear that the PRA does not intend to use it as a tool for driving climate action as this is the responsibility of governments and parliaments, not the financial regulators.

Diverting the capital framework from its core goal could lead to banks’ under-capitalisation, raising a question over their resilience capacities, or over-capitalisation affecting their ability to support the real economy in its transition to net zero.  

He also mentioned that there is little evidence that fine-tuning capital requirements leads to the desired outcomes as shown by the EU’s attempt to support SME lending. In the UK, the PRA has not been given a mandate to perform a similar action.

The current capital regime requires addressing two types of gaps:

• First, “regime gaps” - where the design, methodology or the scope of the framework are not properly calibrated for covering climate risk, e.g., for banks under Pillar 1 framework to calculate potential loss on a one-year time horizon which the time frame is suitable for many risks but not for climate risk.

• Second is “capability gaps” – where data and modelling capabilities need to improve to ensure that climate risk is indeed captured in the regime.

What management should consider:

1) There is perhaps an embedded nudge from the PRA to regulated firms about considering climate impacts significantly beyond the one-year time horizon. Whilst there is no “guidance” or “requirement” on this from the PRA yet, firms might find it useful to start considering a 5-year time-horizon for climate risk analysis. 

2) It is clear that the PRA is going to maintain its focus on data and modelling (refer to the Banking part of the newsletter). It is therefore critical that firms take action on either developing or enhancing their data and modelling capabilities, now.

CBES objectives

The objective of the CBES exercise was to collect banks’ granular analysis of the risks they might face and their strategic responses in three stylised 30-year scenarios:

• An “Early Action” (EA) scenario where climate action begins at the start of the scenario and continues in an orderly manner with global warming reaching the safe 1.8°C temperature rise by the end of scenario horizon.

• A “Late Action” (LA) scenario where action is postponed by a decade and implemented in a sudden and disorderly way. Global warming is limited to 1.8°C.

• A “No Additional Action” (NAA) scenario where no further actions are taken, and global warming reaches 3.3°C. As a consequence of this scenario, physical changes are serious and irreversible. UK and global GDP growth are permanently lower and macroeconomic uncertainty increases.

CBES headlines

The main headline covers the following points (more details are available in this article):

• Based on participating banks and insurers’ projections, overall costs related to transition will be lower in the Early Action scenario.

• Banks and insurers could bear transition cost because a significant part of that cost will be transferred to the ultimate consumers of services. That is specifically true in a No Additional Action scenario where for example general insurers would increase the premiums or refuse to renew insurance for some customers.

• There is a need for banks and insurers to improve their skills in managing these risks in the future.

What are the key lessons learned?

Lesson 1 – Climate risk will become a persistent drag on banks and insurers’ profitability over time with an estimate 10-15% average loss on annual profits. That could be even more severe if the risks are not addressed.

The results of the CBES reflect banks and insurers can absorb the transition cost without raising concerns about their solvency. However, it bears repeating that these results are only projections with a lot of uncertainties and the drag on profitability will leave the sector more vulnerable to next shocks.

Lesson 2 – Costs to the financial sector will be substantially lower in an Early Action scenario, e.g., projected climate-related bank credit losses were 30% higher in the Late Action scenario than the Early Action scenario.

Lesson 3 - The report set out that more funds need to be channelled to low carbon-intensive sectors and less to those that are inconsistent with a net zero policy. However, cutting off finance to carbon-intensive activities suddenly would be counterproductive with negative macroeconomic and societal consequences. 

Lesson 4 – A No Action scenario delivers the worst outcome, e.g., projected impairments rates for banks are up 50% compared to normal levels. Transitions scenarios i.e., Early Action and Late Action offer opportunities by investing in a new economy where the NAA scenario doesn’t offer this and get the world poorer and more uncertain. The outcome would be a reduction to lending and an increase in insurance premium.

Lesson 5 – Banks and insurers have made good progress regarding climate risk management but there is still significant work ahead, including:

• the need for more data on customers’ emissions and transition plan
• need to invest in modelling capabilities
• need for some firms to consider more deeply what would be the best strategic answer through different scenarios.

What lies ahead?

As of today, although climate risk is a priority issue for financial services firms, the PRA does not see the need for introducing changes to capital requirements yet. However, lots of challenges lie ahead and need to be addressed as:

• Are current capital levels set adequately high against an unexpected shock during the transition?
• Does the framework of capital requirements capture climate risk at a sufficiently granular level?
• How do we keep firms having an incentive to improve their capabilities and meet PRAs’ expectations?

What management should consider:Firms, therefore, need to understand, at a granular level, how their balance sheets and business models are exposed to both present and future climate risks so that they can take the right risk management actions today. This includes investing in their data and modelling capabilities, and carefully scrutinizing the data they get from third parties. It means ensuring boards and senior executives see climate risk as a strategic priority, and ultimately ensuring firms hold sufficient financial resources to absorb losses arising from climate change.