The UK’s central bank has published its Climate Biennial Exploratory Scenario (CBES), which explores the major points of risk for the largest UK banks and insurers resulting from climate change.
This evaluates two key sources of climate risk: those arising from structural changes to the economy that will be required to move to net zero emissions (‘transition risk’); and risks associated with higher global temperatures (‘physical risks’).
The Bank identifies several primary objectives for its CBES assessment.
One is to quantify financial exposures of individual firms, and the financial system more broadly, based on their end-of-2020 balance sheets. This aims to shine a light on risks which are currently opaque, according to the Bank.
A second is to understand potential challenges to the business models employed by banks and insurers and to identify implications for the delivery of financial services.
Thirdly, it aims to help firms improve their risk management frameworks and to adopt a strategic view on these risks. This includes building capacity to withstand climate risks and working with major counterparties to understand their vulnerability to climate change.
The Bank has designed the CBES to be an “exploratory exercise” and it will not be used to set capital requirements. Rather, this may be used to guide the Financial Policy Committee’s future approach to systemic policy issues and the Prudential Regulation Authority’s approach to financial supervision.
The exercise will explore three potential scenarios associated with taking “early”, “late” and “no action”, which builds on a scenario analysis methodology developed by the Network for Greening the Financial System. These scenarios are applied over a 30-year term to reflect the “longer term nature of financial risk”.
For banks, the exercise will focus on their credit books, while for insurers it will evaluate risks to both their assets and their liabilities.
Additionally, respondent firms will complete a qualitative questionnaire detailing their approaches to climate risk management and potential management actions.
This is the first time the Bank has tested both banks and insurers to identify the interactions between them and to understand the dangers these present across the financial system.
Bank of England Governor Andrew Bailey says: “This is a novel exercise as firms will have to engage closely with counterparties to get detailed data on those counterparties’ exposures to these risks. It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build their own scenario analysis capabilities, helping them to understand how they are exposed under different potential climate pathways.”
Sarah Breeden, the Bank of England executive sponsor for climate change, says: “The scenarios, which build upon the second iteration of NGFS scenarios released yesterday, provide central banks and supervisors with a common starting point for analysing climate risks under future different pathways.
“Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today.”
The Bank plans to publish the result of the CBES in May 2022.
