Issuing its latest discussion paper, the Bank of England is exploring the stability of the largest banks and insurance firms in the event of the physical and transition risks associated with different possible climate scenarios.
The discussion paper sets out its proposed framework for the 2021 Biennial Exploratory Scenario (‘BES’) exercise.
The report underlines that whilst climate-related risks will materialise over decades, actions today will have a significant impact on the scale of future risks.
It is therefore important that firms, and other stakeholders such as the Bank, continue to develop innovative approaches to measure climate-related risks before it is too late to ensure resilience to them.
The Governor Mark Carney commented: “The BES is a pioneering exercise, which builds on the considerable progress in addressing climate related risks that has already been made by firms, central banks and regulators.
“Climate change will affect the value of virtually every financial asset; the BES will help ensure the core of our financial system is resilient to those changes.”
The BES will use exploratory scenarios to size these future risks and to explore how firms might respond to them materialising, rather than testing firms’ capital adequacy.
The key features of the BES are:
1) Multiple Scenarios that cover climate as well as macro-variables: to test the resilience of the UK’s financial system against the physical and transition risks in three distinct climate scenarios. These range from taking early, late and no additional policy action to meet global climate goals.
2) Broader participation: both banks and insurers are exposed to climate-related risks, and the action of one will spill over to affect the other. For insurers, this exercise builds on the scenarios developed for this year’s insurance stress test.
3) Longer time horizon: is needed as climate-related risks crystallise over a much longer timeframe than conventional risks. The BES proposes a modelling horizon of 30 years.
4) Counterparty-level modelling: a bottom up, granular analysis of counterparties’ business models split by geographies and sectors is proposed to accurately capture the exposure to climate-related risks.
5) Output: the Bank will disclose aggregate results of the financial sector’s resilience to climate-related risk rather than individual firms.
Sarah Breeden the Executive Director sponsor for climate change added: “None of us can know exactly how climate change will unfold, but we do know that it will create risks to the financial system.
“I am excited that this ground-breaking exercise will for the first time allow us to quantify this risk and so determine the actions we need to take today if we are to minimise these future risks.”