The Bank of England kicked off its inaugural stress test of the climate risks facing banks and insurers on Tuesday, but its scope was scaled back after participants raised concerns that they would be unable to model the exposures of potentially thousands of business partners.
The so-called “biennial exploratory scenario” will work out the exposure of the largest UK banks and insurers to climate-related risks, and identify where companies might need to adjust their business models to become more resilient. Both physical risks, such as flooding, and “transition” risks, such as potential regulatory or policy changes, will be considered.
The exercise is “absolutely critical” to understanding “future costs and risks” and informing present-day decision making, said Sarah Breeden, BoE executive sponsor for climate change.
The BoE had initially wanted companies to scrutinise the vulnerability of 80 per cent of their counterparties. That was scaled back to the top 100 counterparties, the top three from certain carbon-intensive sectors, and the top five banks and top five non-bank financial institutions, because companies were concerned about the magnitude of the challenge.
That was “the issue that caused the most consternation, and we adjusted our proposals on the back of that”, said Breeden. Companies were “absolutely most concerned” about having to undertake a granular analysis of the climate plans and risks faced by what could be thousands of companies, she said.
Companies’ end-2020 balance sheets will be tested against three climate scenarios based on the speed and success of limiting global warming over a 30-year period.
The ‘early’, ‘late’ and ‘no policy’ action scenarios — which imply an orderly transition to 1.8C of warming by 2050, a disorderly transition to 1.8C of warming, and no action, resulting in a catastrophic 3.3C of warming, respectively — were based on those developed by the Network for Greening the Financial System and tailored to take account of UK-specific risks and legislation.
Central banks around the world have started embracing climate stress testing, with the European Central Bank and French central bank having published initial findings this year.
BoE governor Andrew Bailey has made clear that the UK tests, results of which are likely to be published next year, will not be used to set higher capital requirements.
“Any incorporation of climate change into regulatory capital requirements would need to be grounded in robust data,” he said last week. “In my view, the case for this has yet to be clearly established and possibly may never be. But our work to improve climate disclosures, scenario analysis, and risk management, could help unlock such assessments.”
Breeden reiterated that stance this week, saying that the stress tests would not affect capital requirements. But she would “not rule out that capital is part of the solution” in the long term.
“Capital needs to reflect risk . . . As we get a better understanding of that risk we can get a better sense of whether capital currently reflects those risks,” she said.
The BoE has already told banks and insurers that they must have “embedded” processes for understanding and managing climate-related risks by the end of the year.
As in a standard remediation process, the BoE could intervene if it believes a company is not managing its climate risks adequately, such as by imposing restrictions on certain activities, requiring it to hold extra capital, or imposing a fine.
Central banks have been keen to impress that they are not responsible for imposing climate policies where governments have not done so.
“The primary levers for driving that transition rest not with central banks, but with governments through setting climate policy,” said Bailey last week.
Breeden said this week that an important job for government was providing “clarity on how we get to net zero”, with detailed, sectoral plans that would have implications for the viability of certain businesses.
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