October 2024
On 27 September, the PRA wrote to CFOs to share thematic feedback on firms’ abilities to quantify the impact of climate risk on their expected credit losses (ECL). While firms continue to make progress in developing their climate risk modelling capabilities, the PRA noted many areas where they could improve the identification and assessment of drivers of climate risk, expand the scope of portfolios assessed for climate risk and include horizon scanning in their climate risk assessments.
The PRA expects firms to act on the feedback and has asked auditors to review progress in addressing the areas of focus in the next round of written auditor reporting.
Overview
In 2023, the PRA set out areas of focus for climate risk and asked auditors for their views on the progress made by firms against them, including:
- Identifying climate-related risk drivers that could influence ECL for loan portfolios with the highest sensitivity to climate risks.
- Use of quantitative analysis on the impact of climate-related risk drivers on ECL and significant increase in credit risk (SICR) at a portfolio level.
- Identifying how economic scenarios and weightings used for ECL calculations should be adapted to incorporate climate-related risk drivers.
The Dear CFO letter sets out the PRA’s thematic findings on each of these topics, based on auditor reports published in 2024, discussions with auditors and firms, and other thematic work.
Thematic findings
The most significant findings relate to:
1. Identifying climate-related risk drivers that could influence ECL for loan portfolios with the highest sensitivity to climate risks
The PRA acknowledges that identifying the loan portfolios and segments that will be most impacted by climate change is a challenge, with firms focusing on physical risks against property and the impact of carbon prices on corporate loans.
Examples of better practice seen across the industry in identifying climate-related risk drivers include expanding the scope of portfolios assessed for risk drivers (e.g. unsecured lending) and the scope of risk drivers considered at a product level (supply chain, litigation, refinancing).
Opportunities for improvement are to expand coverage of portfolios assessed for climate risk drivers, perform more detailed "bottom-up" assessments to identify sub-portfolio specific risk drivers and consider the impact of refinancing risk for higher-risk portfolios. The PRA notes that many firms assume a static balance approach in their climate risk assessments and ignore refinancing risk, with better practice being to include product-level reviews of refinancing risk across both retail and wholesale, considering such impacts as flood risk or regulatory changes on borrower’s ability to refinance.
2. Use of quantitative analysis on the impact of climate-related risk drivers on ECL and significant increase in credit risk (SICR) at a portfolio level
Firms are making progress in analysing the impact of climate-related risks on ECL. However, the use of these analyses to adjust reported ECL is limited. The PRA observed a range of practice including using analysis tools developed for stress testing to allow granular loan-level assessments of climate risk on probability of default (PD), loss given default (LGD) and credit grades, measuring the impact of specific risk drivers on ECL for key portfolios, and considering the impact of physical and transition risks on PD as well as LGD. However, the PRA also noted that many firms continued to rely on expert judgement in their quantitative analysis and that less advanced approaches used simplistic metrics to assess the impact and ECL qualitatively. In addition, some risk drivers, such as supply chain or refinancing risk, remain a challenge for quantitative assessment.
3. Identifying how economic scenarios and weightings used for ECL calculations should be adapted to incorporate climate-related risk drivers
Examples of good practice observed by the PRA include the use of more disruptive downside climate scenarios and incorporating climate-adjusted forecasts of the macro-economic variables used in their existing IFRS9 models. Some firms have also introduced new climate-sensitive variables, such as carbon pricing, into their ECL models in order to capture climate risk. While some firms are benchmarking their macroeconomic variables against external climate scenarios (e.g. from the NGFS) the PRA has also cautioned that too much reliance on high-level benchmarking of macroeconomic variables may fail to identify borrowers or sectors that will be more affected by climate risks than the wider economy.
Areas of focus
The PRA has identified several key near- and medium-term areas of focus on climate risk for 2025. In the near term, firms should challenge the completeness of the climate-related risk drivers used to identify potential ECL impacts and the portfolios most at risk. In their quantitative models, firms should:
- Address the risk that loan losses may exceed those predicted by current models.
- Enhance analytical tools to ensure any conclusions on PMAs are driven by more robust and data-driven quantitative analysis.
- Increase the focus on more granular portfolio level assessments.
- Embed further the impact of climate risks into BAU credit risk assessments for corporate exposures.
- Consider how BAU credit risk assessments can be subject to appropriate levels of challenge.
Finally, firms should consider a broader range of downside climate scenarios and climate-related variables in the economic scenarios used in the ECL calculation. This will allow for timely identification of borrowers and sectors more exposed to climate risk than the wider economy.
Over the medium-term, firms should focus on:
- Identifying the requirement for data and models, and implementing the changes necessary, to factor climate-related risk drivers into loan level ECL estimates.
- To enhance review and monitoring by second line risk teams of how models and scenarios used to calculate ECL incorporate climate-related risk drivers.
What firms should be doing next?
With the publication of the Dear CFO letter, the PRA has signalled that climate risk and scenario analysis will be receiving greater attention from the regulator in 2025. Firms should be:
- Reviewing and validating existing models to ensure that they capture the material drivers of climate risk, can be used to assess the impacts of climate change under a range of short-, medium-, and long-term scenarios, and that they are sufficiently granular to produce informative and actionable information on risk.
- Enhancing climate risk models so that they can provide robust, quantitative scenario analysis that will drive business strategy and incorporate firms lending strategy and risk appetite.
- Embedding climate risk into their BAU processes, including credit scoring, counterparty risk assessment, and provisioning.
KPMG climate risk specialists would be happy to explore the next steps in more detail with you.
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