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Regulatory Briefing: Bank of England publishes green stress test results

By Victor Smart

The Bank of England’s much-anticipated climate change stress test exercise has revealed that UK banks and insurers would take a big, but manageable, hit from a failure to handle risks from global warming.  Results from the so-called Climate Biennial Exploratory Scenario (CBES) estimate that, under a worst-case scenario, banks could incur up to £225bn in credit losses by 2050 and the asset value of insurers could drop 15 per cent.

At this scale of losses sustained over the coming 30 years, climate change would not pose a threat to institutions’ solvency, says the BoE, which conducted the tests last year. But overall, much still needs to be done.

In the BoE’s words: “Climate risks captured in the CBES scenarios are likely to create a drag on the profitability of UK banks and insurers. The Bank’s assessment is that UK banks and insurers still need to do much more to understand and manage their exposure to climate risks. The lack of available data on corporates’ current emissions and future transition plans is a collective issue affecting all participating firms.”

Both the CBES results and how the methodology worked will be eagerly scrutinised by the global financial community. Climate scenario analysis and stress testing are one of the main tools used to address the coverage of climate-related risks, as the Financial Stability Board recently pointed out. And the BoE increased the likelihood that others could use a similar methodology by itself borrowing the scenario models worked up by the Network for Greening the Financial System, which represents most central banks.

The CBES was intended as a learning exercise and, on the face of it, the testing itself worked well. However, the scarcity of consistent, high quality, granular and comparable climate-related data remains a huge handicap for both financial institutions and regulators.

Liability risk. The stress tests look primarily at physical and transition risks. But, significantly, the BoE has also placed a strong new emphasis on so-called litigation risk – a neglected issue for insurers in particular. “Misreading the transition” is one worry that the bank cites: a corporate could be sued by customers on the basis that it continued to sell a carbon-intensive product that it knew would become redundant due to government net zero policy.

For many insurers, this exercise was the first time that they had to draw together information to assess the potential for climate-related litigation across several product lines. In the absence of established processes, several insurers struggled to collate and aggregate the information necessary for a robust assessment of exposures, says the BoE.

A key question is whether the findings are a prelude to regulators imposing increased capital adequacy requirements. The answer is that the BoE certainly does not plan to do so on the basis of this round of tests, and it is adamant that imposing capital buffers is not an appropriate policy tool to avert climate change in the long term – that is the domain of government policy. Nonetheless, it does not rule them out altogether.

The BoE says it is undertaking further analysis to determine whether changes need to be made to the design, use or calibration of the regulatory capital frameworks. “Such changes would be aimed at ensuring appropriate resilience to the financial consequences of climate change,” it adds.

 

A service from the Financial Times