In June 2021, the Bank of England (“BoE”) launched the Climate Biennial Exploratory Scenario (“CBES”) exercise for the UK’s largest banks and insurers. Today, the BoE has released its analysis of participants’ aggregate results. The CBES explored the size of potential losses to the UK financial system against physical and transition risks across three climate policy scenarios – Early Action (“EA”), Late Action (“LA”) and No Additional Action (“NAA”).
The results show a material level of losses, causing persistently lower profitability for firms as well as a significant risk in averaged annualised losses at the end of the NAA scenario for insurers. Losses are especially pertinent when we consider the long-time horizon involved (up to 2050) and the exercise requirements of not allowing for management actions in the NAA scenario. However, unlike the annual cyclical scenario for banks and insurance stress tests for insurers, the CBES was not trying to confirm whether the UK financial system is resilient to climate-related risks. The methodologies used to quantify these risks are still in their infancy and there are data gaps leading to widespread use of proxies, both of which make the results too broad to be able to make that judgement.
In general, banks and life insurers were found to be relatively more exposed to transition risks than general insurers due to assets held in higher carbon intensive sectors, such as mining and manufacturing. However, general insurers were relatively more exposed to physical risks under the NAA scenario due to the impact of insured losses on the liability side of their businesses.
Some may argue that it is difficult to think about the risks of climate change at a time when there are more seemingly immediate issues such as a war in Europe and prices increasing at their fastest rate in 40 years, risking double digit inflation by the end of the year and creating an income shock that is expected to intensify in the near future. This is especially true as, if mismanaged, embedding climate risk could lead to unintended consequences including increasing loan and premium prices, sometimes disproportionately. This could exacerbate the cost-of-living crisis. And climate risks have the potential to cause even greater disruption to our financial system than the shocks we are already facing. According to the latest report of the Intergovernmental Panel on Climate Change (IPCC), without immediate and substantial actions we will not be able to limit global warming to 1.5 degrees Celsius. The results indicate that early, ordered action will also limit losses to the financial sector.
The exercise was successful in directing larger financial services firms to consider climate risks, allocate dedicated resources and start quantifying the impacts. Participating firms have shown ambition to build their capabilities and start understanding these risks and ways in which they can support their customers in their transition to a low carbon economy. Participating firms now need to build on this initial progress to improve their processes and continue to integrate climate-related risks into day-to-day activities. The challenge for the wider market is to learn from the CBES exercise and adopt some of these practices in a cost-effective manner. As such, here are some of the challenges that firms faced in responding to the CBES exercise.
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Data and Modelling Challenges
Climate risk analysis is currently subject to significant data gaps – Some firms estimated loss rates for the same counterparty are ten times higher than other firms. The BoE has clarified that the results represent a first step towards quantifying the financial risks of climate change. Firms need to continue to develop and refine their approaches to climate risk management beyond this exercise, as they embed climate risk processes and tools across their organisations. Firms used data items such as addresses, postcodes, energy Performance certificates (EPCs), industry codes, countries of incorporation and operation, and insurance flags for the first time in a regulatory exercise, which left a challenge to align data. Firms should continue to build strategic solutions to integrate this data, as successfully sourcing and mapping these to traditional and climate data is crucial to climate risk modelling. As firms consider expanding the reach of their modelling, they should enhance collection to include data for calculating secondary risk channels and other aspects of ESG.
The CBES required banking and life insurance participants to engage with their corporate counterparties to obtain a greater accuracy and coverage of information. Firms struggled with this aspect of the exercise. While many larger counterparties could answer the questions asked of them, some smaller counterparties were unable to submit meaningful data. Since the exercise, counterparties’ consideration of climate risk has expanded and requirements to make TCFD-aligned disclosures are being introduced across the UK. Client outreach is a valuable strategy for data acquisition in the early stages of embedding climate risks and beyond. Firms should consider engaging in periodic client outreach to harness counterparties’ sector knowledge and alleviate the difficulty, should they need to repeat the exercise.
While the exercise provided scope for participants to determine their own approaches to the modelling, there was also a requirement to calibrate climate models to the dataset provided by the BoE. Some participants found difficulty in aligning to the data provided, which is likely indicative of the uncertainty inherent in these models at this early stage in their adoption and so the wide range of possible results. As this area of modelling continues to develop and to drive disclosures, there will need to be an increasing focus on validating the output of climate models against both internal and external information.
Financing the Transition and Credible Transition Plans
The CBES offered an early framework for assessing client transition plans. This catalysed the development of transition plans by participating firms and sparked engagement with their clients, in turn accelerating the development of their corporate transition plans. Firms are starting to understand the range of vulnerabilities and resilience to climate change of their customers. However, this was a theoretical exercise. Firms must leverage this tool and others to create a meaningful strategy for the low carbon economy.
Financial institutions are uniquely placed to accelerate the net zero transition. In investments, this can be done using a combination of divestment, green financing or supporting their customers’ transitions. Insurers have a further role in incentivising green choices for their personal and commercial customers, providing products to support new technologies and utilising the claims fulfilment process to provide green repairs. Targeting green financing and divestment strategies is not enough – Firms need to actively engage their clients to help them manage the transition in a fair and balanced way. As such, actively supporting customer transitions is emerging as the best way firms can support the economy-wide transition, as well as that of their own portfolios. Sam Woods has said banks and insurers should continue financing counterparties in carbon-intensive industries, to allow them to invest in the transition.
Climate as a strategic question
The qualitative questionnaire challenged firms to consider climate risk across a range of areas, considering risk management processes, resource gaps and future plans as well as the details of the quantitative modelling. While there has been significant focus on the risks associated with climate change, this part of the exercise also asked participants to think about opportunities. For both banks and insurers, the opportunity to develop new products to support new technologies or to make novel, green construction methods insurable will allow financial institutions to have a profound impact on the adoption of these emerging approaches. Ultimately, the decision as to where to focus is one of strategy and the exercise gave participants a chance to think at a much more granular level about their overall climate strategy, considering for example what it really means to be a market leader in this area.
The exercise, and in particular the qualitative questionnaire, encouraged firms to seek input from a wide range of stakeholders from across the business as well as requiring Board-level challenge of the outputs. This part of the exercise also allowed broader consideration of some of the less quantifiable risks, such as litigation risk which may be a key concern for insurers writing some liability lines. For many, this may have provided the first opportunity to put climate risk high on the agenda across all parts of the business, allowing firms to further develop climate strategy, not solely based on the model outputs but also on the diverse range of views gathered from key stakeholders.
Supervisory focus
In line with SS3/19, climate-related risk is increasingly being incorporated into supervisory activities and firms will need to actively demonstrate the management of climate risks throughout their business-as-usual activities. Although the CBES was not a capital setting exercise, it has helped to implement and progress SS3/19 across firms. However, more needs to be done on firms’ governance, management and disclosures related to climate risk. Regulators are actively considering whether and how climate risks should be incorporated into prudential frameworks. It is still unclear what this may look like. The Network for Greening the Financial System (NGFS) published a progress report suggesting that current modelling practices are not mature enough to successfully introduce adjustment factors to the Pillar 1 framework. Rather, the report suggests that Pillar 2 measures may be more suitable to address climate risk alongside Pillar 3 disclosures in this early stage.
The results suggest that industry-wide capital may be sufficient, but that more needs to be done to ensure it is held in the appropriate places. Steven Maijoor, a De Nederlandsche Bank (DNB) board member responsible for Supervision suggested a new approach to prudential monitoring altogether, by introducing a concentration limit on exposures. Firms who continue to improve their climate risk practices will not only see a competitive advantage but are less likely to fall foul of potential prudential tools. Adding or rearranging capital is certainly not ruled out. Sam Woods has indicated that the BoE could introduce incentives if firms are not building the capabilities they require.
Climate change represents only a small subset of the factors considered under the umbrella of ESG. Since the announcement of CBES in 2019, the regulatory community has increasingly recognised the importance of broader environmental risks such as biodiversity loss. As well as environmental factors, companies are progressively expected to disclose on social issues such as human slavery and the gender pay gap. Therefore, Institutions should expect regulatory expectations in these areas to increase.
Conclusion
The exercise was successful as a first step in understanding the potential financial losses of climate change, but there is more for firms and central bankers to do.
Data remains the greatest issue in climate risk calculations. Client outreach and a deliberate data strategy will improve model outputs.
The second round highlighted the need to align counterparty transition plans and those of Banks and insurers who need to understand and guide customer transitions.
Finally, firms should prepare for enhanced supervision from regulators, begging the questions: What will be the scope and focus of future CBES exercises? And how will climate-related risks be introduced into the capital regime, particularly given its current focus on a one-year time horizon?
How KPMG are helping clients
Our key propositions include:
- Building on the results and processes of the CBES exercise to embed climate risk into day-to-day risk management frameworks
- Improving climate risk stress testing, utilising our own proprietary Climate IQ modelling tool
- Enhancing data & systems strategies, including client outreach frameworks
- Developing credible transition strategies and assessing client transition plans
- Understanding the nexus between climate, biodiversity and ESG to assess a wider range of risks
