UK: PRA provides banks with feedback on accounting for climate risk

The Prudential Regulation Authority has sent a Dear CFO letter to a selection of banks providing feedback from its thematic review of written auditor reports received in 2023. Among other matters, the review included its findings on accounting for climate risks. The aim of the findings is to encourage banks to identify improvements that can be made in capabilities in quantifying the impact of climate risk on expected credit loss (ECL). The PRA suggests they will also be helpful for firms applying IFRS that are not in scope of written auditor reporting.

Main findings on climate risks

Near term areas of focus include:

• Identifying the climate-related risk drivers that could influence ECL for loan portfolios that have the highest sensitivity to climate risks. The PRA found that determining the right metrics to identify the loan portfolios and segments that could be most impacted by climate risk remains a challenge. The PRA sees opportunity for firms to further expand the coverage of portfolios for which climate risk drivers are formally assessed and to perform more detailed ‘bottom-up’ assessments to ensure the identification of risk drivers relevant to sub-portfolios. The PRA said it was not apparent whether or how firms had included refinancing risk and encourages firms to consider the impact of refinancing risk for high-risk portfolio. 
   
• Use of quantitative analysis on the impact of climate-related risk drivers on ECL and significant increase in credit risk at a portfolio level. The PRA sees further opportunities for firms to enhance and expand frameworks for factoring climate risk into business-as-usual credit risk assessments for corporate exposures.
   
• Identifying how economic scenarios and weightings used for ECL calculations should be adapted to incorporate climate-related risk drivers. The PRA sees different approaches emerging in how firms are adapting economic scenarios to incorporate climate-related risk drivers. It sees scope for firms to consider a broader range of climate scenarios and indicators to allow for timely identification of borrowers and sectors more exposed to climate risk than the wider economy.

Medium term areas of focus include:

• Identifying the requirement for data and models, and implementing the changes necessary, to factor climate-related risk drivers into loan level ECL estimates. Firms are at various stages of developing new ‘climate aware’ models. As understanding of climate related risk drivers improves, the PRA see scope for firms to further enhance data and processes to challenge the completeness of overlays and embed climate risks in loan-level credit risk assessments.
   
• Enhance review and monitoring by second line risk teams of how models and scenarios used to calculate ECL incorporate climate-related risk drivers. The PRA encourages firms to continue to progress their plans to develop more climate aware models to reduce reliance on top-down approaches used for stress testing purposes.

Next round

For the next round of written auditor reporting, the PRA has asked for auditors’ views on the firm’s progress against the areas of focus on ECL set out in the letter. The PRA encourages firms to engage with their auditor by performing their own assessment against the areas of focus.

In 2025, the PRA plan to focus on disclosures to help users understand the effect of climate risk on firms’ exposure to credit risk, how the effect of climate risk has been considered in ECL measurement, and underlying assumptions and judgements.