Climate and Sustainability - Q3 2022

Supervision of climate-related financial risks and CBES Scenario exercise

The last quarter saw significant developments in climate scenario analysis and stress testing, and more broadly in supervisory assessment of financial firms’ management of climate-related financial risks.

In the UK, the PRA released a letter from Sam Woods on the Thematic feedback on the PRA’s supervision of climate-related financial risk and the Bank of England’s Climate Biennial Exploratory Scenario exercise relevant to all UK insurance and reinsurance firms and groups, banks, building societies, and PRA designated investment firms. Internationally, the NGFS shared the third vintage of climate scenarios for forward looking climate risks assessment relevant across jurisdictions, while in the EU ECB published the results of its 2022 Climate Stress Test relevant to European financial institutions, including European banks that operate in the UK.

Insights

Although performed in two different jurisdictions (UK and EU), the PRA and ECB climate stress test results reveal similar messages, i.e., besides making significant progress, financial firms need to continue their work to understand and address climate risks.

The letter released by PRA outlines the gaps and further steps it wishes financial firms to undertake to comply with the expectations set in its Supervisory Statement 3/19 published in April 2019. Overall, the PRA observed that banks and insurers have taken concrete and positive steps to implement the expectations. However, the levels of embedding differ, and the general assessment is that further progress is needed by all financial firms. To assist financial firms, especially the mid and small size, in complying with the expectations, the PRA provides a list of resources, including principles and guidance (Annex C of the document). With regards to the four key supervisory framework areas, the PRA shares the following observations:

• Governance – financial firms “had generally been able to implement an effective level of climate governance and had ensured that key personnel are appropriately trained to understand and manage climate risk. Some firms had generated regular climate-related management information, leaving their Executives and Boards well placed to provide effective leadership and challenge (…).” 

• Risk Management – financial firms “had made progress on risk management, but there are significant variations in the maturity of their processes (…). In many cases, work is still required to finalise embedding of climate risk considerations within their risk management framework (RMF), risk appetite statement (RAS), committee structures, and each of the three lines of defence, utilising both qualitative and quantitative measures. Consequently, most firms’ work on climate risk management and mitigation (including capital allocation) was still maturing.” Less effective practices covered insufficiently developed RMFs that compromised the Board and Executive’s ability to effectively manage climate risks, lack of complete picture of counterparties’ exposures or transition plans impacting their understanding of the level of climate risk in their current portfolio, and still insufficiently developed methodologies for calculating capital buffers against material climate exposures.

• Scenario Analysis – financial firms have not sufficiently developed scenario analysis capabilities to inform decision-making. The main constraints were in “the generation, collation, cleaning, analysis, and integration of data to conduct decision-useful scenario analysis, with strong links to business strategy.” Further improvements are expected in defining objectives of scenario analysis, scenario design and use of results in ICAAP and ORSA processes.

• Disclosures – financial firms have made progress but need to continue to evolve their disclosures as they develop their understanding of the climate risks relevant to their business. Many firms, which did not disclose material climate risks in their Pillar 3 and SFCR disclosures, provide no proof of why the firm’s climate risks were considered immaterial.

• Data – financial firms need to further improve data. Most financial firms were reliant on third parties for data, models, and other components of risk management or were unable to obtain the relevant data, while some continued to flag data gaps as obstacles to the determination of views on climate-related risks. 

The PRA expects financial firms to continue developing approaches to capture climate risk in balance sheet valuations. The PRA expects firms’ financial reporting-related priorities for 2022 and beyond to include enhancing:

• Data and modelling capabilities to quantify the impact of climate change on balance sheets and financial performance.
• Governance and controls to support use of a higher volume of forward-looking climate-related data in financial reporting.
• Disclosures that help market participants understand the linkage between firms’ climate-related disclosures and the impact on their financial statements and Pillar 3 reporting.

The updated NGFS climate scenarios provide a new benchmark for regulators running climate scenario exercises and for financial firms utilising NGFS scenarios for the development of internal climate scenarios. The key updates include incorporation of countries’ commitments to reach net-zero emissions, increased sectoral granularity and improved representation of physical risk, including acute risks.

Further remarks

Financial firms are expected to further enhance their climate risk management frameworks with specific focus on amending their climate risk methodologies, data, scenario analysis capabilities, disclosures, and validation approaches. Although not yet specified, capital regulatory requirements are being discussed by PRA at a wider financial forum, and the firms should closely watch regulatory developments in this space.

ESG integration in the capital markets

In June 2022, the FCA published a feedback statement following its consultation a year earlier which included ESG integration in UK capital markets. The feedback statement set out the FCA’s response to views received around the following areas covered in the consultation:

• Issues related to ESG-labelled instruments
• ESG data and rating providers

Issues related to ESG labelled instruments

Advertisements, Prospectus and “Use of Proceed” (UoP) bond framework

With concerns on the negative impacts of having more stringent terms in contractual agreement and enhancing information on use of proceeds disclosed in prospectus, the FCA confirmed there would be no change to the current prospectus rules framework. However, the FCA plans to reassess its position based on the outcome of Treasury’s proposals to reform the UK’s regime for public offers of securities and admissions to the trading on capital markets. In the interim, asset issuers and their advisors were encouraged to consider voluntary adoption of industry standards on the issuance of ESG-labelled UoP debt instruments such as the ICMA Principles and Guidelines for green, social and sustainability bonds as well as the CBI’s Climate Bonds Standards.

Verifiers and Second Party Opinion (SPO) providers

The FCA will consider working with the Treasury and FRC to include verifiers and SPO providers under its regulatory remit to provide additional oversight over these firms. The FCA encouraged asset issuers and their advisors to consider relevant industry standards, such as the ICMA Guidelines, when selecting verifiers and SPO providers, who in turn should consider voluntary adoption of relevant industry standards and codes of conduct.

ESG Data and Rating providers

Regulatory oversight

As ESG data and rating play a critical role in the investment process and can cause material potential harm, the FCA is considering greater oversight on providers of this information. The FCA is looking towards a regime that will adopt a proportionate, targeted, and phased approach to regulation in this area. As developing such a regime can take time, ESG data and rating providers are encouraged to consider implementing a voluntary code of conduct which will cover areas such as transparency, conflict of interest, governance/systems, and controls.

Further remarks

Overall, key messages from the FCA centre around voluntary adoption of relevant industry standards, increasing regulatory oversight, and seeking a regulatory approach that is globally consistent. This is welcome news as these will help promote quality, discipline, and further integrity of the market.

While the regulatory framework is being more defined, asset owners and managers should consider taking actions such as:

• Identifying established industry standards, they want to comply with and assessing the extent to which their existing processes, reporting and disclosures align with these standards. They should also consider the level of assurance to put in place to provide additional comfort to stakeholders and the wider market.

• Seeking to better understand the inputs and methodologies used to determine outputs provided by third parties such as SPO and ESG data providers. This may require internal upskilling to effectively challenge the information provided.