On 18 June 2020, the Bank of England (the Bank) released its first report regarding its own exposures to climate change-related financial risks and its proposed strategy to manage those risks effectively. It has done so bearing in mind its expectations (as set out in Supervisory Statement 3/19 dated 15 April 2019) for financial firms, including all UK insurance and reinsurance firms, to consider the same up to the highest level of executive management.
The global finance community, including the Bank, appears to accept that financial risks from climate change fall into two primary risk factors: physical risk factors and transition risk factors. (We touched on physical and transition risks in our previous article which you can access here).
Within its report, the Bank discusses:
- Its approach to climate-related risk disclosure
- The governance structures and processes it uses to manage climate-related financial risk
- Its approach to setting a climate strategy and managing its implementation and
- Its approach to climate-related financial risk management, including its targets and the metrics its uses to track its progress.
We analyse each of the four points discussed by the report in turn below.
Approach to climate-related risk disclosure
The Bank has broadly adopted the recommendations of the Task Force on Climate-related Financial Disclosures which prescribe “a foundation to improve investors’ and others’ ability to assess and price climate-related risk and opportunities appropriately” by reference to four core elements: (i) governance; (ii) strategy; (iii) risk management; and (iv) metric and targets.
To assist with this approach, the Bank engaged climate data providers to provide a metric on the carbon footprint, transition risks and physical risks present in the Bank’s sovereign and corporate holdings. While this step may not be necessary or appropriate for all financial firms, the Supervisory Statement indicates that such analysis must go beyond consideration of historical data and may include stress testing and/or catastrophe modelling. Firms should have regard to whether there are any gaps in their understanding of climate-related financial risks and whether additional data/analysis could assist in closing or reducing those gaps.
The Bank has sought to integrate considerations of climate issues within its governance structures, supplemented by climate-specific governance and risk processes where required. It has assigned an Executive Sponsor to hold responsibility for climate risk issues and the Executive Sponsor is responsible for providing recommendations on strategy for addressing climate-related financial risk and the implementation of that strategy. This accords with the PRA (Prudential Regulatory Authority)’s expectation that banks and insurers will assign a Senior Management Function responsible for these issues.
The Bank also reports on how its Court of Directors considers the Bank’s approach and reviews its progress. As discussed above, the PRA will require firms to evidence that climate-related risks are being considered up to the highest levels of executive management. Firms should be considering how to integrate such discussion into current governance structures, and whether additional committees or other governance procedures would assist with this process.
“The Bank’s climate strategy is focused on understanding and mitigating the financial risks from climate change.” In doing so, it is focused on ensuring that firms invest now to develop capabilities on how to measure exposures, which could be “far-reaching in breadth and magnitude”, and it will continue to monitor firms’ progress as part of its supervisory framework.
Its strategy can be summarised as follows:
- Risk: “ensuring firms and investors can measure and manage the financial risks from climate change”;
- Reporting: “improving the quantity and quality of climate-related disclosures”; and
- Return: “using the Bank’s policy and regulation work to better equip firms and investors to identify the frictions and opportunities in the transition to a carbon-neutral economy”.
Risk management, metrics and targets
The Bank has confirmed that it seeks to include climate risks within its current risk management framework, complemented by specific climate-related risk process where appropriate.
Its approach includes seeking to improve its understanding of these risks across its functions, collecting information on the climate exposures of its key suppliers, and taking further steps to enhance its risk management processes to more fully address climate-related risks.
Within this section of the report, the Bank sets outs its current carbon footprint targets, and its methods of identifying, assessing and managing climate-related risks, such as how these risks form part of their assessment of transaction counterparties and collateral. It also discusses how it completed an “in-depth” exercise with its external providers to assist the climate-related financial risks to its asset portfolio. It includes metric on the carbon footprint of the portfolios and measures of transition and physical risk to those portfolios.
The Bank has produced this report “as a prominent public institution sitting at the centre of the financial system, and a market participant in its own right”. The question is, what does this mean for its fellow “market participants”, i.e. the regulated firms?
While firms are not presently required to produce their own public disclosures regarding their approach to climate-related financial risks, the Bank’s report may influence the decision on whether such reporting should be mandatory. The Bank itself states that it is a “strong advocate for widespread adoption of climate-related financial disclosure to help ensure climate risks can be considered in each financial decision.”
In the meantime, the report may be considered as useful guidance for firms as to how to approach the identification and management of climate-related financial exposures, in accordance with the PRA’s requirements.