Bank of England launches new climate stress scenario

Insurers and banks have been given a new set of tests which will allow regulators to see how they can withstand the impacts of climate risks.

The Bank of England published the Climate Biennial Exploratory Scenario (CBES) to explore the financial risks posed by climate change for the largest UK banks and insurers, with an accent on how the two interact to identify and support exposures.

The CBES uses three scenarios of early, late and no additional action to explore the two key risks from climate change: the risks arising from the significant structural changes to the economy needed to achieve net zero emissions – ‘transition risk’ and risks associated with higher global temperatures – ‘physical risks’.

Andrew Bailey the Governor of the Bank of England (above) said: “This exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole. It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks.

“It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”

He added this was the first time the bank was testing both banks and insurers to allow it to capture interactions between them and understand the risks presented by climate change across the financial system.

The key features of the CBES are:

  • Three scenarios of early, late and no action built on a subset of the Network for Greening the Financial System (NGFS) scenarios: these are applied over a span of thirty years reflecting the longer[1]term nature of climate-related risks.
  • Sizing the risks participants face based on their current (fixed) balance sheets: for banks, the exercise will focus on their credit books, whilst for insurers, the exercise will assess risks to both their assets and liabilities.
  • Qualitative questionnaire: this will capture participants’ own views on their risks, their approach to climate risk management, and their potential management actions, and
  • Detailed counterparty-level analysis for the largest counterparties: the CBES asks firms to use novel modelling approaches to conduct a detailed, bottom-up analysis of their largest counterparties. For the remainder of counterparties, firms are expected to differentiate exposures by geography and sector. The Bank intends the CBES to be a learning exercise. Experience and expertise in modelling climate-related risks is still relatively immature, so this exercise will develop the capabilities of both the Bank and the CBES participants.

The bank said the objectives of the exercise are to:

  • Size the financial exposures of individual firms and the financial system to their end-2020 balance sheets: this will shine a light on risks that are currently opaque.
  • Understand business model challenges and likely responses to these risks: this will highlight where action may be needed and any implications for the provision of financial services, and
  • Improve firms’ risk management and prompt a strategic view: this includes building capability, both amongst participants and within the Bank.

The exercise will also encourage participants to engage their largest counterparties to understand their vulnerability to climate change. The CBES is an exploratory exercise. It will not be used by the Bank to set capital requirements. Instead, participants’ submissions may inform the Financial Policy Committee’s future approach to system-wide policy issues, and the Prudential Regulation Authority’s (PRA) future supervisory approach.

Sarah Breeden, the Bank of England Executive Sponsor for climate change said: “We are excited to launch today’s climate scenarios, which build upon the second iteration of NGFS scenarios released on Tuesday. They provide central banks and supervisors around the globe with a common starting point for analysing climate risks under different future pathways. Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system. Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today. I encourage all firms, not just those participating, to engage in and learn from this exercise.”

The Bank said it expected to publish the CBES results in May 2022.

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