On 24 May 2022, the Bank of England (BoE) published the results of the Climate Biennial Explanatory Scenario (CBES), the first exploratory scenario exercise on climate risk, involving the largest UK banks and insurers.
The BoE asked banks and insurers participating in the CBES to use three scenarios to look at how climate related risks could affect them, in order to model how their businesses could be affected in each scenario. Two scenarios featured policies to limit global temperature rises (early action and late action scenario) with the third being unchecked global warming.
The BoE’s assessment is that, whilst UK banks and insurers have made good progress in some aspects of their climate risk management, they still need to do more to understand and manage their exposure to climate risks. Climate risks captured in the CBES are likely to create a drag on the profitability of banks and insurers, particularly if they are unable to manage these risks effectively. Also, the lack of available data on corporates’ current emissions and future transition plans is a collective issue affecting all participating firms.
Key findings of the CBES were:
- Projections of climate losses are uncertain. Scenario analysis in this area is still in its infancy and there are several notable data gaps. Progress needs to be made by banks and insurers to understand and manage their exposure to climate risks.
- At an aggregate level, UK banks and insurers are likely to be able to absorb the costs of transition that fall on them. The overall costs will be lowest with early and well managed action to reduce greenhouse gas emissions. Some costs that initially fall on banks and insurers will ultimately be passed on to their customers.
- Some responses – to the third scenario in particular – implied a material reduction in access to lending and insurance for sectors and households which were most exposed to physical risks. In the third scenario, banks would reduce lending to properties facing greater physical risks, and insurers would substantially increase the premiums they charge to insure against such risks, making insurance coverage unaffordable for many of these households.
- One recurrent theme across participants’ submissions was a lack of data on many key factors that participants need to understand to manage climate risks. All participating firms have more work to do to improve their climate risk management capabilities. The BoE will engage with firms individually and collectively to help them target their efforts, and share good practices identified in this exercise.
- Governments set public climate policy, which will be a key determinant of the speed and shape of changes in the global economy. Banks and insurers have a collective interest in managing climate related financial risks in a way that supports transition over time.
The findings from the CBES exercise will feed into the Financial Policy Committee’s thinking around financial stability policy issues related to climate risk.
The BoE will help the banks and insurers it regulates to use the results of the CBES to improve their climate risk management capabilities, both through individual firm supervisory dialogue and by sharing and discussing key thematic findings with the banking and insurance industry more broadly (including through the Climate Financial Risk Forum).
The firm-specific findings of the CBES will inform ongoing dialogue about the management of climate risks between participating firms and their supervisors. For example, evidence gathered through the CBES will help the PRA to assess firms’ progress against the PRA’s expectations in this area (as set out in Supervisory Statement 3/19), and help to reveal where more intensive action is needed by firms to address the issues identified.
On the same date, the BoE published a speech by Sam Woods (Deputy Governor for prudential regulation and CEO of the PRA) entitled ‘Climate capital’. Mr Woods specifically highlighted the following results from the CBES:
- The stylised scenarios used in this exercise are illustrations of possible paths for climate policy and global warming, but not forecasts. Additionally, overall costs will be lowest with early, well-managed action to reduce greenhouse gas emissions and so limit climate change.
- Over time climate risks will become a persistent drag on banks’ and insurers’ profitability, particularly if not managed effectively. While they vary across firms and scenarios, overall loss rates are equivalent to an average drag on annual profits of around 10-15%.
- Costs to the financial sector will be considerably lower if early, orderly action is taken.
- There remains a need for more data, an investment in modelling capabilities and for firms to consider more deeply how they would respond strategically to different scenarios.
- The BoE will host a research conference on the interaction between climate change and capital in Q4 2022. The BoE will also publish follow up material on the use of capital, including the role of any future scenario exercises, informed by the conference and the findings of the CBES.