The PRA has published a Dear CEO letter setting out thematic observations on firms’ levels of embeddedness of their approaches to managing climate risk since the PRA published its supervisory statement (SS3/19) in April 2019. The letter draws from the findings of the Bank of England’s Climate Biennial Exploratory Scenario exercise which was published in May 2022 (see our earlier post) and provides examples of effective practices identified.
Overall, the PRA has observed that banks and insurers across the sector have taken concrete and positive steps to implement its expectations. However, while some firms have made considerable progress, the levels of embedding vary and the assessment of supervisors is that further progress is needed by all firms.
Next Steps
The letter notes that compliance with the expectations in SS3/19 will be assessed on an ongoing basis and firms should continue to demonstrate effective management of climate risks through regular supervisory engagements and reviews. It is particularly important that Board and the senior management team, including the designated Senior Manager Function for climate, demonstrate appropriate oversight and control of the firm wide climate agenda. Firms judged not to have made sufficient progress in embedding PRA expectations should expect to be asked to provide a roadmap explaining how they intend to overcome the gaps.
What are the PRA’s observations on firms’ progress in responding to SS3/19?
Governance
Firms have generally been able to implement an effective level of climate governance and have ensured that key personnel are appropriately trained to understand and manage climate risk.
Examples of effective practice | Examples of less effective practice |
Board oversight - Within the most effective firms there was a coherent approach to climate across these four areas, which was supported by appropriate metrics and risk appetites that effectively measure vulnerabilities to climate risk. For international firms, this meant that climate-related metrics were being monitored across regions and management information was cascaded across relevant governance forums. Other examples included: embedding climate risk factors into strategic planning activities and senior remuneration targets; linking scenario analysis outputs to business strategies; firm-wide training to build capabilities; and continuing development of the scope, quality, and frequency of climate-related information provided to senior committees. Responsible Senior Manager – The majority of firms now include an allocated Senior Manager Function (SMF) with responsibility for the financial risks from climate change. These individuals are charged with providing effective oversight of climate risks in a holistic manner, and some firms had incorporated climate-related objectives into the SMF’s remuneration. To be effective, SMFs should be able to speak to – and take appropriate ownership over – the broad institutional strategy for the financial risks from climate change. | (None provided) |
Risk Management
In general, the PRA found that firms had made progress on risk management, but there are significant variations in the maturity of their processes and further work is required by all firms. In many cases, work is still required to finalise embedding of climate risk considerations within their RMF, RAS, committee structures, and each of the three lines of defence, utilising both qualitative and quantitative measures. Consequently, most firms’ work on climate risk management and mitigation (including capital allocation) was still maturing.
Examples of effective practice | Examples of less effective practice |
Risk management frameworks and tolerances – The PRA observed that firms demonstrating effective practice had a RMF in place for climate and were implementing a well-defined, quantitative RAS, which effectively supported the firm in the identification, measurement, monitoring, management, and reporting of climate risks. In the most effective firms, the RAS was coherent with the overarching RMF, included quantitative risk limits and metrics, and was tailored to the firm’s business strategy, business model, and balance sheet. Modelling – As part of their RMF work, some firms exhibiting effective practice were able to demonstrate that climate risk had been appropriately factored into their quantitative analysis; for example through well-developed quantitative climate risk modelling capabilities and utilisation of prudent assumptions and proxies where data challenges existed, coupled with concurrent work to address the data gaps identified. Capital – Some firms were holding capital for climate risks. The most effective firms had undertaken a methodical consideration of how climate risks could impact capital. This had allowed them to explain why they are, or are not, holding specific capital for those risks. | Risk management frameworks and tolerances – In some firms, the lack of an effective RMF for climate risks appeared to be compromising the Board and Executive’s ability to effectively manage those risks. In those firms, the RMF often did not include quantitative risk appetite metrics, and there was little evidence that the RMF was impacting climate strategy or decision making. Many firms were still developing and implementing their RAS for climate risks and, in some firms, the RAS did not include any quantitative elements. For insurers, climate risk management for underwriting practices generally required further consideration by management and embedding into existing process. For banks, some firms did not yet have clear timelines for incorporation of climate factors into their credit processes, and, where plans did exist, they did not always align to the bank’s plans for developing data and modelling capabilities. Counterparties’ exposures – Data on counterparties’ transition plans and on their evolving exposures to climate risks (both transition and physical risk) is needed to understand climate risks in the wholesale book. In general, banks did not have a complete picture of counterparties’ exposures or transition plans, and had faced challenges in sourcing this information. Banks demonstrating effective practice had a process in train to develop their counterparty engagement processes to collect this data and then incorporate it into their risk management processes. As analysis of climate risks progresses, some firms were considering whether they would ultimately exit particular customers or sectors and, if so, how they would manage that process in an orderly manner. In developing their thinking, they were taking into consideration the potential impact on wider market dynamics, for example, the potential need to support those sectors considered integral to the transition to net zero. Capital – The PRA found that the methodologies firms had used to demonstrate that they are holding adequate capital against material climate exposures were generally maturing. In the majority of cases, firms did not provide sufficient contextual information to enable a reader to fully understand their analysis. For example, firms often provided minimal information on modelling approaches, model types, underlying assumptions, judgements, proxies, and consequent uncertainties. |
Scenario Analysis
In general, the PRA’s findings indicated that scenario analysis capabilities were not sufficiently well developed to support effective decision-making. The primary constraints were in the generation, collation, cleaning, analysis, and integration of data in order to conduct decision-useful scenario analysis, with strong links to business strategy. For example, a limited number of firms were using scenario analysis to consider the impact of climate risks on future revenue projections.
Where firms were using climate risk models, the PRA generally found that they were still in the early stages of development, with some firms making use of a combination of new models, existing models and third-party solutions to estimate impacts. Of those firms, all were making use of proxies, manual adjustments, and simplifying assumptions, but there was limited information on how those data gaps and methodological challenges will be addressed.
Examples of effective practice | Examples of less effective practice |
Scenario design – The PRA observed a large degree of variability in firms’ loss modelling. Firms demonstrating effective practice considered the uncertainty in their climate risk analysis, and took this into account when using the results, for example, through the use of prudent assumptions, manual adjustments or sensitivity analysis to understand how results would change should events play out in different ways. For insurers, examples of effective practice demonstrated by some firms included an ability to model a wide range of physical vulnerabilities in their assessment of underwriting risk, and the ability to identify and address the limitations of the third-party models used. | Contextual information – Climate scenario analysis is complex in a number of areas. This means that different frameworks and scenario calibrations are required to deliver specific outcomes. While one framework might meet one objective, it should be expected that it would not meet all objectives. For example, a fixed balance sheet exercise designed to test business model vulnerabilities over decades allows a firm to understand the risks and opportunities to its business over the specified period, but may not be an appropriate tool with which to calibrate capital. Many firms were not yet able to articulate the objectives, for which their scenario exercise had been designed, or the ways in which their approach had been calibrated to meet those objectives. Consistency – The PRA observed that, in some cases, it was not clear whether firms had integrated the outputs from their scenario analysis into their ICAAP and ORSA processes, using appropriately prudent calibrations and assumptions where required. It was also unclear whether scenario analysis had been used to inform the calibration of risk appetite metrics. Scenario design – In some cases, the PRA found it was not clear whether firms had taken steps to ensure that data and assumptions were consistent with the relevant scenario. Effective scenario analysis involves running scenarios that are relevant to a firm’s business, and that appropriately test the firm’s specific vulnerabilities. For example, firms should consider both probabilistic events (e.g. changes in average weather patterns) and tail events (ego extreme weather events). More progress is required to embed physical risk in corporate modelling. This is a particularly difficult area due to the range of impact channels, the lack of available data, and the consequent nascence of model development. The PRA found that approaches ranged from predominantly judgemental to more detailed analysis of asset loss by counterparties, with limited consideration of how physical risk would impact counterparties’ supply chains and the markets, in which they operate. Other areas where the PRA found that banks made use of simplifications were: modelling of mortgage physical risk, including by considering a wider range of vulnerabilities and extreme weather events; commercial real estate; consumer credit; and financial institutions and sovereigns. Banks need to rapidly build capability in these areas to reduce the amount of simplification within their models. |
Disclosure
While most firms had developed an approach to disclosure of climate risks, in general, the PRA found that work to be promising, reflecting its dependence on progress made in other areas of SS3/19 (e.g., risk management and scenario analysis). All firms will need to continue to evolve their disclosures as they develop their understanding of the climate risks relevant to their business. In general, the PRA observed that firms’ Pillar 3 disclosures and Solvency and Financial Condition Report (SFCR) disclosures were not being used as the primary means for firms to disclose their climate risks. Instead, firms were generally choosing to set out their primary climate risk disclosures in their Annual Report or a standalone climate report. Many firms’ Pillar 3 and SFCR disclosures were mainly used to report high-level summaries of governance frameworks and internal committee structures.
Examples of effective practice | Examples of less effective practice |
In line with Taskforce on Climate-related Financial Disclosures (TCFD) recommendations, firms demonstrating effective practice included climate disclosures in ’mainstream filings’ and employed a consistent and integrated approach across all forms of annual reporting. For example, they provided consistent messaging across financial reports, standalone climate disclosures, and Pillar 3 or SFCR disclosures, with cross-referencing where required to avoid duplication and facilitate accessibility. | Firms demonstrating less effective practice provided limited disclosures and / or little or no contextual information to support their climate disclosures. For example, many firms, which did not disclose material climate risks in their Pillar 3 and SFCR disclosures, provided no information to indicate why the firm’s climate risks were considered to be immaterial. |
Data
The PRA observed that, although data is being used effectively by some firms, all firms were in need of more robust, standardised climate-related data of sufficient coverage. Most firms were reliant on third parties for data, models, and other components of risk management or were unable to obtain the relevant data. Some firms continued to flag data gaps as obstacles to the determination of views on risks. While gaps will mean that an end-state process might not be achievable, interim approaches that utilise proxies are required.
Examples of effective practice | Examples of less effective practice |
Approach to address gaps – The PRA observed that firms demonstrating effective practice had identified their significant data gaps and were developing a strategic approach to close those gaps. They considered the requirements for reliance on third party providers8 and balanced the use of those providers with strategic development of in-house capabilities over the short, medium, and longer-term. The PRA found that firms demonstrating effective practice had in place an effective system of governance to oversee and integrate the third-party data provided. Interim measures – While data gaps were being addressed, firms demonstrating effective practice used appropriately conservative assumptions and proxies. Use of these estimates was documented internally and disclosed to the extent that it was necessary for a reader to interpret climate publications or submissions (e.g., climate disclosure reports aligned with the TCFD, ORSAs, and ICAAPs). | (None listed) |
Climate and Accounting
Recognising that firms are at an early stage in developing approaches to capture climate risk in balance sheet valuations, the PRA (with the view that timely incorporation of climate risk in accounting valuations is important in ensuring the safety and soundness of PRA-authorised firms) nevertheless set out their expectations that firms should, prepare for the impact of climate risk on their accounting practices. As such, the PRA will continue to work with firms to share concerns, facilitate cross-industry solutions, and promote high quality implementation of accounting standards. It expects firms to engage openly and cooperatively as they develop the governance, processes, and capabilities to monitor the impact of climate risk for financial reporting, including embedding robust governance, controls, and assurance over new data sources. The PRA anticipates that firms’ approaches to integrating climate risk into financial reporting processes will evolve for several years, and expects firms to make the resources and budgets available for several years to enable this to happen on a timely basis.
The letter published on 21 October 2022 is available here.
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