Climate change stress testing and the Bank of England's requirements

Central banks have become increasingly involved in the debate over climate change and the impact on the financial system. The Bank of England (BoE) has been a leader in encouraging banks and insurers to assess their exposures to global warming and the risks associated with any transition to a lower carbon economy.

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The BoE published its first ever climate-related financial disclosure for itself in June 2020, setting out its approach to managing the risks from climate change across its entire operations and explaining what it is doing to improve its understanding of these risks. In 2019 it became the first major international regulator to introduce mandatory climate change stress tests with the Climate Biennial Exploratory Scenario (CBES). This initial program was aimed solely at insurance companies, to analyse how their businesses would be affected in different physical and transition climate risk scenarios.

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Continuing in its stance as the leading regulatory body in this area, the BoE announced its second CBES in November 2020 for June 2021 – this time to include banks and insurance companies. The Banque De France is also launching a similar exercise in 2021.

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The ECB has scheduled the launch of its first climate change stress testing program for the middle of 2022. Following the election of Joe Biden as President, US regulators are preparing to follow suit. Mandatory climate change stress testing should thus become customary soon, across all major economies.

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Taskforce on Climate-Related Financial Disclosures (TCFD)

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To date, the UK and other countries have applied the disclosure principles guidelines from the global Taskforce on Climate-Related Financial Disclosures (TCFD) for companies on a voluntary basis, except for UK insurance companies. The guidelines were first published in 2017 to provide companies with a financial disclosure guide to better inform financial markets and investors.

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The guidelines focus on making recommended disclosures across the following areas:

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• Governance – Describing the board’s oversight of climate-related risks and opportunities and explaining management’s role in assessing and managing risks and opportunities
• Strategy – Disclosing the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning where such information is material. This includes describing the climate-related risks and opportunities identified over the short, medium, and long term; highlighting the impact of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning; as well as describing the resilience of the organisation’s strategy, taking into consideration different climate-related scenarios, including a 2°C temperature shift
• Risk Management – Showing how the organisation identifies, assesses, and manages climate-related risks. To do this the company needs to describe its processes for identifying and assessing climate-related risks. It also needs to demonstrate its processes for managing climate-related risks; as well as showing how these processes are integrated into the organisation’s overall risk management framework
• Metrics & Targets – Disclosing metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material. It also includes a three-scope tiering for greenhouse gas emissions, and the related risks, as well as targets for companies to manage climate-related risks and opportunities against targets

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In addition, specific guidance is provided by the TCFD for Banks, Insurance Companies, Asset Owners, Asset Managers and Non-Financial Groups.

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However, it has become clear that mandatory regulatory action is required. The TCFD principles are not detailed enough to properly compare companies and more forward-looking measures are necessary. To help drive down carbon emissions, a single mandatory framework for companies to disclose the risks from climate change is needed.

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June 2021 Climate Biennial Exploratory Scenario (CBES) – Stress Tests

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Despite projected delays due to the pandemic and lockdown, the BoE’s governor, Andrew Bailey, announced in November 2020 that the climate change stress testing program for banks and insurers is to be launched for June 2021. The stress testing regime is limited at this stage – Asset Management Firms are not included in the 2021 directive but will need to continue to adopt TCFD principles to demonstrate their credentials.

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The June stress tests will require regulated entities to focus on transition as well as physical risks, which include the following challenges:

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• Transition Risks – Adapting to climate change will require organisations to change behaviours at an unprecedented pace. The ability to adapt to improve the sustainability of products and services will require both clear management strategies but also considerable capital investment. Exposure to polluting companies and business will be damaging and bring consequences to cashflows and access to capital
• Physical Risks – Natural catastrophes are becoming increasingly frequent – the likes of which have not been witnessed in historical times. Unprecedented shocks are expected, driven by increasingly frequent and powerful storms, droughts, and erratic weather patterns

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The CBES exercise is designed to test the resilience of the largest banks and insurers against these transition and physical risks associated with different potential climate scenarios, and the financial system’s exposure more broadly to climate-related risk.

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Therefore, banks and insurers are looking at a regime that will require them to:

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• Create a tiered approach with detailed assessments for their top 100 non-financial corporate exposures
• Carry out extra counterparty-level analysis on their three largest exposures / companies in the sectors most impacted by the CBES scenarios
• State the number of counterparties and the proportion of corporate exposure they were able to analyse at a detailed counterparty level
• Assess their counterparties’ current activities, which will include estimating their contributions to climate change

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The BoE will explore litigation risk as part of the CBES. They have proposed a quantitative approach for general insurers and a set of qualitative questions for other participants. The balance sheet cut-off date for the CBES is the end of 2020. Three climate scenarios will be used in the exercise. Early policy action; late policy action and no policy action.

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Banking participants will focus on the impact to credit risk on banking book assets, whereas insurers will calculate the effect of scenarios in line with the approach taken in their 2019 Insurance Climate Stress Test. The impact from market / traded risk will not be included in this initial CBES exercise.

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This means that regulated entities should start work immediately to be prepared for June. They need to begin collecting the necessary data from their counterparties in the wider economy to understand how they are exposed to climate-related risks and opportunities.

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Regulated firms also need to identify the datasets that they will need. Obtaining physical risk data will be difficult and they will need to build datasets to cover all the potential risks, scenarios, countries, and regions.

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For physical risks, companies are required to build distributional frameworks around the frequency and severity of perils to complete the analysis. They will also need to review the indicative list of variables provided by the BoE and prepare to give feedback on which variables are essential in each of the three scenarios.

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In line with other stress tests, there will be the requirement to undertake scenario expansion to investigate extra variables. The initial expectation for participants is to focus on more challenging and resource intensive areas; for instance, where there are exposures to long supply chains or sectors where climate change reporting is new.

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It will be optimal to engage with efforts being taken by industry bodies to streamline the data collection process, whilst being mindful of gaps to be filled via a company’s own bilateral engagement.

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By the end of 2021 It is expected that companies will have embedded their approach for managing risk, on the issue of climate change.

Holley Holland works closely with its partner, Quant Foundry Limited. QF has been at the forefront of climate risk research for nearly two years. Dr Chris Cormack and the QF team has designed and built an innovative risk model to address transition and climate risks from counterparties, real estate portfolios and more. Their research has been published in peer reviewed journals and used commercially.‍

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QF has also developed an advisory service, to help companies develop their understanding of climate risks and build the risk infrastructure to meet the stress test objectives and then embed the capability across their business model. Their solution for banks was developed to accelerate climate change capabilities; capturing transition and physical risks and how they manifest into credit, operational, and market risks – ultimately to assimilate them into their Pillar 2 and ICAAP disclosures for climate risks.

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More details on the modelling framework and QF’s ability to assess asset level physical risks and the impact on financial instruments can be found here.

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The Quant Foundry Climate Modelling overview can be found here.