Results of the Bank of England’s climate stress test

The results of the Bank of England’s (BoE) inaugural climate risk-related stress testing exercise, the Climate Biennial Exploratory Scenario 2021 (CBES), have now been published, concluding that, although UK banks and insurers are making good progress in some aspects of their climate risk management, much more needs to be done to understand and manage their exposure to climate risks.    

The BoE warns, unsurprisingly, that climate risks are likely to create a drag on the profitability of UK banks and insurers (particularly banks and life insurers), noting that projections indicate that overall costs will be lowest with early, well-managed action to limit climate change. 

Given the infancy of stress tests of this nature and the known data gaps, the CBES results were never intended give rise to capital increases. However, the BoE will engage with firms individually and collectively to help them target their efforts and share any good practices identified in this exercise.  

One point of interest that was highlighted by the BoE was the dangers associated with UK banks and insurers moving too quickly to remove their exposure to certain sectors as a result of transition to net zero policies. In this context, the BoE referred to it being in the interests of banks and insurers to “gradually” reduce those exposures where counterparties have credible transition plans and it also referred to the banks’ and insurers’ views that clear and well communicated climate policy will assist in this transition. This focus on “credible transition” and the balance between reductions in exposures to carbon-intensive counterparties and the need to increase investment in sustainable energy solutions is set to be a key theme for 2022.

Background

Launched in June 2021, the CBES was designed to stress-test the resilience of some of the largest financial institutions in the UK, in the face of the climate related risks they are facing, including both transition risks (arising from the significant structural changes to the economy needed to achieve net zero emissions), as well as physical risks (associated with the impact of higher global temperatures).

The analysis tested financial institutions’ end-2020 balance sheets against three climate scenarios:

• early action scenario (EA) – an ambitious transition to net zero between 2021 and 2050, with global warming successfully limited to 1.8°C by 2050, falling to 1.5°C by the end of the century;
• late action scenario (LA) – a more sudden/disordered and delayed transition to net zero beginning in 2031, with global warming limited to 1.8°C degrees by 2050, but then remaining around that level at the end of the century;
• no additional action scenario (NAA) – a deliberately severe scenario involving implementing no new climate policies and no transition to net zero, resulting in global temperature levels continuing to rise and reaching 3.3°C higher by 2050.

The three key objectives of the exercise were to:

• Improve banks’ and insurers’ climate risk management – banks and insurers were asked to model risks at a granular level, including by engaging with their largest counterparties to understand better their climate exposures.
• Size the risks that participants in the exercise face – projections were based on their current balance sheets: for banks, the exercise focused on their credit books, whilst for insurers the exercise assessed risks to both their assets and liabilities.
• Better understand the potential responses of banks and insurers to climate-related risks and their broader implications – and a second round of the exercise was run in part to gauge participants’ reactions to their initial responses.

Results

In a speech to the Global Association of Risk Professionals following the release of the stress test results, Sam Woods, Deputy Governor for Prudential Regulation and Chief Executive Officer of the Prudential Regulation Authority, set out the key lessons emerging from the exercise and some of the key takeaways, as follows:

• Based on this exercise, whilst over time climate risks will become a persistent drag on banks’ and insurers’ profitability, the costs of a transition to net zero look absorbable for banks and insurers without a worrying direct impact on their solvency.  
• That being said, there is a lot of uncertainty in these projections, not to mention that the drag on profitability will leave the sector more vulnerable to other, future shocks. 
• The timing and extent of climate action has a significant bearing on the degree of losses and risk that might be suffered, with climate-related credit losses for banks under the late action scenario 30% higher than the early action scenario. Loss rates for banks under the late action scenario were projected to more than double as a result of climate risk, leading to an extra £110 billion of losses. As such, early action is important to lower the cost of the transition (bearing in mind, however, that the financial sector cannot run ahead of the real economy).
• The NAA scenario delivers the worst outcome. Whilst a simple comparison of estimated loss rates under each of the scenarios might suggest otherwise, this is misleading due to the very different end points of the scenarios (and under NAA, unlike the other two scenarios, the impact of climate change would persist beyond 2050, incurring substantial economic costs not captured in the estimates). The results also highlight the significant impact to climate vulnerable households and sectors under the NAA scenario, as assets exposed to physical climate risk could become prohibitively expensive to insure or borrow against.

So what does this mean for policy?

Clearly the CBES will be a valuable tool for helping the regulator and financial institutions to understand the challenges ahead.

The BoE will give firms feedback on the quality of their CBES submissions and areas for improvement, and findings on climate risk management will feed into the assessment of firms against the BoE’s supervisory expectations (as set out in SS3/19).

The BoE will also use the CBES results to inform ongoing work on climate risks, amongst other things feeding into the Financial Policy Committee’s thinking around financial stability policy issues related to climate change. 

And what about regulatory capital?

It should be noted that the BoE has commented that this exercise will not be used to set capital requirements related to climate risk. The BoE does not consider regulatory capital to be an appropriate tool to address the underlying causes of climate change (that responsibility lies with governments, businesses and households), and in his speech Woods too reiterated that it is “not yet clear that the magnitude of transition costs require a fundamental recalibration of capital requirements for the system”. 

However, the BoE will be exploring this further, and will be holding a conference to discuss this later in the year, and has already put out a call for papers on the interaction between climate change and capital. 

Woods did however highlight a few key questions/challenges for the PRA, which could be an indication of future workstreams in this area:

• To the extent that climate change makes the distribution of future shocks nastier, that could imply higher capital requirements, all else being equal. A key question will be whether current capital levels are sufficiently high to guard against unexpected shocks during the transition.
• Even if capital levels are appropriate in aggregate, that does not mean that the capital is held in the right places. Some of the climate risks are highly concentrated in particular sectors, as such a second key question will be whether or not the framework of capital requirements capture climate risk at a sufficiently granular level.
• The PRA also needs to ensure firms have the right incentives to continue to improve their capabilities, and meet its expectations. From the point of view of capital, the PRA will be focussed on whether it is satisfied that firms are building the capabilities they need – and if not, whether it needs to introduce more incentives.

Most fundamentally, the CBES results are a snapshot – based on current data and modelling capabilities, and focused on a specific set of scenarios and risks. As capabilities build, regulators will be better able to size the risk and its potential policy implications. It will also become clearer over time whether the real world looks more like the EA scenario, or if we are living in a ‘late’ or ‘no’ action world. All of this will inform the PRA’s judgements about capital requirements and any other responses to climate risks.

Lessons for future climate stress tests?

The BoE intended for the CBES to be a learning exercise. Expertise in modelling climate-related risks is in its infancy, so this exercise was designed to develop the capabilities of both the BoE and CBES participants. The BoE intends to share the key themes and lessons learned from this exercise with its peers, helping to advance understanding of the risks that climate change poses to the global financial system. This collaboration should also help to reduce the level of fragmentation across jurisdictions as they each address climate risks that are global in nature.

So whilst the CBES report is an important step forward, it is certainly not the last word.

You can find a copy of the results (published on 24 May 2022) here and the BoE’s press release here.