Banks are increasingly being pressed to report climate risks to their business. We chart the global drive to gauge the financial industry’s climate resilience.
This article is part of our 2021 Global Bank Review – ESG: Creating a purposeful future, an annual publication by our Global Banks Sector Group which brings together our people who live and breathe banks.
It is currently much in vogue among regulators to remind banks that tackling physical and transition risks from climate change is key to prudential risk management of financial systems. This message was summed up in recent comments of European Central Bank (ECB) executive board member Isabel Schnabel: “Climate change will in the future play just as much of a role in banking supervision as in our monetary policy measures.”
The last 12 months have seen regulators mandating banks and insurers to assess risks to the finance system as the global economy aspires to go carbon neutral. As we analyse the progress across key financial hubs, it is clear this journey has barely begun: if stress-test exercises ask, “Are you ready?”, the truthful answer is still largely “not yet”.
Ongoing stress testing – key global hubs
Under its prudential oversight of the financial system, the Bank of England launched its Climate Biennial Exploratory Scenario (CBES) in June 2021. Delayed from 2020 by the pandemic, the CBES is a stress-testing exercise to assess financial risks from climate change and explore participants' resilience.
Participation is limited to large UK banks and building societies, large UK life insurers and large UK general insurers, involving just under 20 entities, and a sample of 10 Lloyd's syndicates, collectively representing a large proportion of banking and insurance business conducted in the UK.
The CBES captures climate-related factors in physical and transition risks, such as potential flooding and risks from policy changes. Its 30-year timeline extends beyond horizons usual in stress testing to reflect the long-term challenges of the area. Participants must adopt three climate scenarios, based on scenarios established by the Network for Greening the Financial System (NGFS):
- early policy action, where transition to a carbon-neutral economy begins in 2021;
- late policy action, where transition begins in 2031; and
- no additional policy action.
Guidance has been given on physical and transition risks associated with each scenario.
Participants are likely to focus on three elements as they respond:
- Assessing their own credit risk based on current, fixed balance sheet exposure. This involves gathering data, developing modelling, and adopting assumptions for climate-related financial risks. The 'data gap' has been an often-cited concern in consultation.
- Engaging key counterparties. Responses involve the assessment of participants’ largest exposures and the assessment of counterparty exposures in sectors vulnerable to climate change. This expands the reach of the CBES far beyond its named participants, although requirements for counterparty analysis were cut back from initial proposals to assess 80% of each institution’s counterparties after concerns were raised regarding scale.
- Governance practices. Participants are invited to complete a qualitative questionnaire describing their approach to risk management, consideration of climate litigation risk, and potential mitigation.
Participants had until October 2021 to make initial submissions; results are due to be published by May 2022 on an aggregated basis.
Lessons learned could quickly define prudential regulation of UK finance for climate risks, though the Bank of England has disavowed the suggestion that it will use the results to set capital requirements.
In December 2020, the Hong Kong Monetary Authority (HKMA) wrote to locally licensed banks to invite them to join a pilot in 2021. The exercise involves analysis of physical and transition climate risk but participation is voluntary and involves the banking industry only.
The physical risk scenario focuses on Hong Kong's projected climate situation, such as increases in temperature, rises in sea levels and more intense cyclones. Transition risk scenarios include an orderly transition, assuming early and progressive action to achieve climate goals, and a disorderly transition with abrupt policy shifts. Participating banks were asked to evaluate short-term as well as long-term financial impact under the scenarios.
The HKMA encouraged banks to explore new methodologies for the pilot, given that traditional stress testing may not be suitable for environmental factors. The regulator also offered some flexibility to participating banks given the lack of established practice.
Separately, in July 2021 the HKMA released a draft of a proposed new guidance note, GS-1, on climate risk management for consultation. The draft sets out HKMA expectations in four areas for building climate resilience: governance, strategy, risk management and disclosure. The HKMA proposed a 12-month period for implementation of the requirements when finalised. The guidance is applicable to Hong Kong-incorporated banks as well as local operations of foreign banking groups.
The Australian Prudential Regulation Authority (APRA) finalised its Climate Vulnerability Assessment (CVA) in summer 2021. In September 2021, it published further details of the CVA, which is being completed by Australia's five largest banks.
The APRA has stated the exercise is not intended to lead directly to capital requirements but concedes that results are intended to support "strategic decision making" regarding climate risks.
APRA's design also draws upon NGFS scenarios, identifying two scenarios for use:
- delayed transition – disorderly transition to 2050 with current climate policies to 2030 and a rapid reduction in GHG emissions after 2030; and
- continuation of the current trajectory – a "hot-house world" scenario.
There is no scenario for an "orderly" transition to a greener economy.
The CVA adopts credit risk as the primary lens to assess climate risk, addressing exposures on a 30-year horizon.
The CVA will capture counterparty liabilities but only includes assessments for 25 material, non-finance corporate exposures for each participating bank. Guidance is provided on the breadth of those exposures but the scale is less expansive than either the UK or European equivalents.
The CVA includes a questionnaire to make a qualitative assessment of market, liquidity and operational risks, as well as their impact on firms’ funding positions.
The regulator will publish results of the exercise in aggregated form in 2022.
Completed stress tests
“Climate change will in the future play just as much of a role in banking supervision as in our monetary policy measures.”
Elsewhere in Europe, regulators have already completed climate-related stress tests.
In May 2021, the French ACPR published results of an exercise involving 24 participants. Participation was voluntary, using a 30-year horizon and involving banks and insurers. The review covered transition and physical risks.
The ACPR noted in its findings that it was subject to several "methodological difficulties". One was the challenge in confirming geographical location of institutions’ exposures at group level. Others included modelling challenges, gaps in counterparty data and lack of integration of climate considerations into firms' existing risk architecture.
The overall findings cited "moderate" exposure of the financial sector to transition risks and "significant" increases to insurance premiums following crystallisation of physical risks.
The ECB and European Banking Authority
The ECB recently published results of its region-wide assessment on 22 September 2021. This was a top-down exercise, relying on internal data sets covering around four million companies globally through counterparty analysis, and 1,600 consolidated banks (almost all banks in the European Economic Area). The ECB describes the coverage as “the most comprehensive set of… climate and financial information available at central bank level”. The ECB’s approach was data and model driven and – unlike French and UK initiatives – did not include self-assessment. Echoing international equivalents, the ECB drew on established NGFS scenarios.
ECB President Christine Lagarde observed that the “findings demonstrate a clear benefit to acting early and ensuring an orderly transition. While transition costs may be higher in the short term, they are much lower in the long run than the costs of unrestrained climate change.”
Preliminary findings note that “[a]round a third of the loans that euro area banks have granted to firms are – to a significant or increasing degree − exposed to climate risks from extreme weather events".
In addition to emphasising the importance of early action, the ECB highlighted negative impacts of inaction or a delayed response. Focusing on physical risks in a “hot-house world” scenario, it painted a stark picture of lack of creditworthiness, soaring defaults and social cost across geographies most at risk from extreme weather.
The report anticipates it will be used to develop scenarios and support bottom-up analysis by the ECB for banking supervision. A “thematic” review of climate risks has been announced for 2022, which will look in greater detail at institutions’ internal stress-testing.
The paper may also feed into the climate stress test for the Eurosystem balance sheet, which is part of the ECB Strategy Review’s climate action plan, due in early 2022.
Meanwhile, the European Banking Authority (EBA) published the results of its pilot scenario analysis in May 2021. The exercise sought granular data from 29 banks and 10 large corporates on a voluntary basis. The EBA found participating banks showed a higher level of expected loss in the NGFS “hot-house world” scenario than disorderly or orderly transition models.
When, not if
“Findings demonstrate a clear benefit to acting early and ensuring an orderly transition. While transition costs may be higher in the short term, they are much lower in the long run than the costs of unrestrained climate change.”
Despite global momentum, it remains striking that the US has been slow so far in addressing banks’ financial exposures to climate change. The Federal Reserve Bank of New York (the Fed) has, however, reportedly asked lenders in supervisory discussions to provide information on their measures to mitigate climate risks. A recent report by the Fed on climate stress testing also shows climate resilience receiving greater regulatory attention in the US. Moreover, many see stress testing as likely under an administration which returned the US to the Paris Agreement within hours of President Biden’s inauguration, not to mention the Fed joining the NGFS in December 2020.
As pressure to tackle climate change mounts, regulators are likely to favour decisive action even if the precise form of that action remains unresolved. The HKMA has indicated the main objectives of its pilot were to assess climate resilience of Hong Kong’s banking sector and facilitate participating banks in building better assessment models for climate risk. While UK and Australian regulators state stress testing will not trigger immediate changes to capital requirements, it seems only a matter of time before such considerations influence capital policy.
What is certain is that by carrying out stress-testing exercises, prudential regulators will gain significant insights into institutions’ approaches to managing the financial risks stemming from climate change and firms’ proposed response to such risks. Indeed, banks’ ability to conduct analysis of corporate exposures will feed into supervisors’ views of the calibre of lenders’ data and climate risk management capabilities. The direction of travel is now clear. Firms have been warned.