Climate-related risks and the regulatory capital framework

The Bank of England (BoE) has published a report summarising its latest thinking on climate risks and regulatory capital frameworks. The report brings together key findings, building on the PRA's 2021 Climate Change Adaptation Report (CCAR), and including the research submitted in support of the BoE's October 2022 Climate and Capital conference. This latest report poses further questions to banks and insurers to help progress the BoE's work on climate and capital frameworks.

It is important to note that this is not a consultation and puts forward no specific policy proposals or timelines for change. However, the BoE identifies some regime gaps which may need to be addressed with specific tools — leaning towards Pillar 2 approaches and broader macro prudential approaches such as concentration limits, specific buffers and addressing insurance protection gaps.

The BoE's overarching findings are that:

• Existing capability gaps (reflecting the inherent difficulties in identifying and measuring climate risks), and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses.
• Effective risk-management controls within PRA-regulated firms can reduce the amount of capital required in the future — the absence of such controls may support the need for higher capital requirements.
• Capturing climate risks in capital frameworks requires a more forward-looking approach than that used for many other risks. Scenario analysis and stress testing will play a key role and firms are expected to make further progress in this area.
• Current evidence suggests that the existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks, therefore policy changes to time horizons do not appear justified.
• Further work is needed to assess whether there may be a regime gap in the macroprudential framework.
  

More detailed analysis focuses on the materiality of gaps in the capture of climate risks in capital frameworks and on capability and regime gaps.

1. Materiality of gaps

• The risk that firms may be insufficiently capitalised to deal with future climate-related risks is compounded by capability gaps in the existing regulatory regime, which makes it difficult to gauge whether the risks are within regulators' risk appetites.
• The BoE will take a judgement-based approach to policy making based on iterative understanding of the uncertainties of capital adequacy and climate resilience. This may result in a gradual approach to policy development. Given material uncertainties about the resilience to climate risk, the burden of proof required for policy action is yet to be fully determined.
• The BoE will explore whether a broader range of regulatory tools might be appropriate. This could include concentration limit approaches and other macroprudential tools.

2. Capability gaps in the capital frameworks

In the short term, the BoE is focused on ensuring that firms make progress to address capability gaps to improve their identification, measurement, and management of climate risks.

• While the PRA does not expect firms to have embedded a perfected framework for climate risk measurement yet, they should demonstrate continual progress and ambition.
• It is the responsibility of firms to determine capital adequacy. They must be able to disclose sufficient information regarding their internal capital adequacy assessment process (ICAAP) or own risk and solvency assessment (ORSA), and readers should be able to understand their analysis of climate risk and capital. Where this is not the case, the PRA will consider whether further supervisory action is required.
• The PRA will continue to support the ISSB and other international bodies to promote the implementation of consistent and comparable disclosure standards for climate risks, to provide banks and insurers with high quality and consistent information.
  

3. Regime gaps in the capital frameworks

• Following the publication of climate stress testing (CBES) results in 2022, the PRA intends to review improvements in firms' internal capabilities and progress against feedback recommendations as part of the supervisory process.
• The PRA will also expect firms to step up their implementation of SS3/19 and address the gaps identified in the PRA `Dear CEO' letter of October 2022.
• Climate scenario analysis requires a more forward-looking approach than other risks considered in the supervisory process. The BoE, PRA and other regulators will continue to develop the supervisory approach to ensure that capability gaps are overcome, but firms will also need to take responsibility for refining scenario analysis and risk modelling process.
• The BoE and PRA do not currently plan to make changes to regulatory policy regarding the time horizon over which climate change risks are considered.
• The BoE is exploring the extent to which aspects of climate risk are not adequately reflected in the existing regulatory regime. This includes:
  • Differences in how banks and insurers are affected by climate risk, and how this should be reflected in the capital framework.
  • The extent to which systematic risks not addressed by microprudential capital requirements will arise from climate risk, for example, whether insurers' matching adjustment benefit reflects how assets could become more exposed to climate risk over time.
  • Maintaining coherence between the climate supervisory approach and the approach to other risks.
  • Ensuring that the BoE and PRA's supervisory mandates are used fully for the purposes of monitoring climate risk.

Other authorities and regulators are also continuing to progress their work on climate and capital frameworks:

• In its May 2022 discussion paper on the role of environmental risks in the prudential framework, the EBA proposed that Pillar I might have the capacity to reflect climate-related risks, but that adjustments to the mechanism would be required to fully and appropriately incorporate these factors.
• The Basel Committee for Banking Supervision's (BCBS's) June 2022 principles for the effective supervision and supervision of climate-related risks set out expectations for banks and prudential supervisors to appropriately manage climate-related risks. The principles contribute towards a globally consistent baseline of management and supervision, whilst allowing for flexibility and innovation. In February 2023, the BCBS also published FAQs on capturing climate risk in the Basel Framework — for more, see our article here.
• The ECB has published thematic feedback on its expectations of firms in relation to climate and environmental risk — for more detailed analysis, see our previous article.
• EIOPA is assessing whether a dedicated prudential treatment of assets and activities associated with environmental or social objectives under Solvency II would be warranted, in line with the European Commission's proposals for the Solvency II Directive. EIOPA set out its thinking in a discussion paper released in December 2022. Further analysis can be found here.
• The International Association of Insurance Supervisors (IAIS) is revising its guidance on supervisory approaches on climate risk and looking to potentially update how climate is integrated into Insurance Core Principles (ICPs). In March 2023, the IAIS released the first of a series of consultations to shape its work over the coming 18 months.

As noted above, there are no policy changes announced in the report. However, there are strong indications from the BoE that it expects firms to ensure that they bridge capacity/risk management gaps or face potentially higher capital requirements. In the longer term, this could be via regime change, but in the more immediate future the PRA could decide to impose higher capital requirements for the laggards — for insurers, this could be via an additional capital add-on or through the use of the PRA's expected new tools as part of the Matching adjustment reforms.

Firms should expect that the prudential framework will evolve and that, in the future, top-down macroprudential tools may be developed to reflect the systematic risk from climate change. While this evolution takes place, firms would be wise to focus on improving their own capabilities and ensuring that they are meeting current supervisory expectations.