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Bank of England climate stress test warns of losses to come

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The Bank of England (BoE) has released the results of its most recent financial stress test, showing that the financial system should be able to manage the impact of the net-zero transition.

Despite the positive note, the BoE says climate risk could hit profit by 10-15% – around £225 billion in a “no action” scenario. What’s most interesting about the report, though, is what it fails to address.

What’s the Bank of England climate stress test?

The BoE is part of the global Network for Greening the Financial System (NGFS), a network of central banks and regulators concerned that the financial risks from both the physical and transition risks associated with a shift to a net-zero economy could affect the stability of the financial system, and specifically affect the vulnerability of banks and insurers to market shocks.

The stress test, or what the BoE calls the Climate Biennial Exploratory Scenario (CBES), is a technique to understand how resilient financial institutions and portfolios are under a range of different scenarios and built on scenarios developed by the NGFS.

The purpose of such an exercise is to get a sense of how large the risks being faced are, to drive action on risk management in banks and insurers and to understand how the sector might respond to the wider consequences of climate risk.

The 2021 climate stress test

The 2021 CBES assessed the impact of three different scenarios on 19 banks and insurers over the next thirty years. The exercise considered two possible routes to net-zero UK greenhouse gas (GHG) emissions by 2050: an ‘Early Action’ (EA) scenario and a ‘Late Action’ (LA) scenario.

A third ‘No Additional Action’ (NAA) scenario explores the physical risks that would begin to materialise if governments around the world fail to enact policy responses to global warming.

The BoE made clear that CBES scenarios are not forecasts of likely future outcomes but rather, “they are plausible representations of what might happen based on different future paths of climate policies, technological developments and consumer behaviour, aimed at limiting the rise in global temperatures.”

Unsurprisingly, there was a wide variation in losses associated with different institutions and scenarios. This is in part due to difference in impact type – such as the impact on insurers of extreme weather events versus credit risk to banks – and in part due to the different ways in which different institutions assess risk.

There is also uncertainty about when climate risks will have impact. In the LA scenario, overall projected losses were 30% higher, while for the insurance industry in particular, annualised losses could increase between 50% and 70%.

Net-zero transition losses to vary by sector and geographical area

While the Bank’s assessment is that UK banks and insurers are in a good position to manage forthcoming shocks, it also warned that “the Bank’s assessment is that UK banks and insurers still need to do much more to understand and manage their exposure to climate risks.

“The lack of available data on corporates’ current emissions and future transition plans is a collective issue affecting all participating firms.’

This is a significant concern when considering what is left out of the CBES.

While the CBES identified potential impacts through defined scenario analysis, a recent paper in a leading academic journal identified the specific link between policy and specific oil and gas assets likely to be affected by climate risk.

This included publicly listed companies with $1.27 trillion of stranded assets, with a further $681 billion of assets at risk owned by financial institutions.

There will also be geographical differences, with $300 billion each at risk in the US and Russia, with a further $100 billion at risk in both China and Canada.

While a global rather than a UK figure, the research highlights the specific impacts that might occur.

It’s worth noting that, according to the research, 88% of these ‘at-risk’ assets are currently owned by wealthier countries of the Organisation for Economic Co-operation and Development (OECD) – and their governments have direct exposure to $484 billion of potential losses through current asset ownership.

There is no doubt that transition to net zero is going to have impact on far more than the fossil fuel industry – it’s going to affect different sectors in different ways. New business models, innovation and shifts in market expectations can and will have a dramatic impact on the financial system.

Risks outside the CBES

At the very least, the BoE admitted, there are climate risks outside the CBES – such as bank trading losses and mortality risk for insurers. These could be material and there is uncertainty about the magnitude of such risks.

One of the most obvious would be the economic implications if policy or market related limits on lending and insurance to fossil fuel companies start to have an impact before energy efficiency measures and renewable energy capacity are sufficient to fulfil misplaced energy demand.

This is a particular concern given the current energy crisis and concern about rising energy costs and inflation. If, as the BoE suggest, financial services manage by passing costs along to customers, this would also have knock-on economic effects through higher cost of credit or cost of premiums, as well as changes to asset allocation and reinsurance programmes.

Data fundamental to mitigate impact of transition

Sam Woods, deputy government for prudential regulation and chief executive of the Prudential Regulation Authority, said in a speech: “Over time, climate risks will become a persistent drag on banks’ and insurers’ profitability – particularly if they don’t manage them effectively… [but] by themselves, these are not the kinds of losses that would make me question the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition.”

There is no doubt that how and when net-zero transition takes place matters – with the BoE stating clearly that the impact and cost will be far lower if transition is managed early, in an orderly and structured fashion.

What comes across most clearly, however, is how sensitive scenario modelling is to underlying assumptions – these range from carbon prices, actual warming and its impact, or even the actions taken by companies and financial institutions to address the impact.

Woods admitted in his speech that the “error bands around all these estimates are very wide” in terms of the CBES. It’s possible that the error might be in favour of less impact, but growing evidence of growing pollution, falling biodiversity and more extreme weather suggests that we are only seeing the beginning of a major operational shift.

Financial institutions and companies alike need to understand how business models and balance sheets are exposed to climate risk, both today and in the future. Given that these assumptions are based on available data, the focus on reliable and accurate data becomes increasingly clear.

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