Stress-testing for banks was first introduced as a response to the financial crisis in 2008/2009, and is used by the Bank of England (BoE) to assess how banks can cope with severe economic scenarios in terms of capital requirements.
In December 2019, the BoE issued a discussion paper and sought consultation on a proposed framework for climate stress testing. The exercise, called the Climate Biennial Exploratory Scenario (CBES), will test the resilience of the current business models of the largest banks and insurers to climate related risks. The aim is to analyse the scale of adjustment that will be needed in coming decades for the financial system to remain climate resilient.
The news of the CBES stress test came as the PRA outlined its insurance supervision priorities for 2021 in a letter to chief executives. The ‘Dear CEO letter of 1 July 2020’ requested that firms should have fully embedded their approaches to managing climate-related financial risks by the end of 2021.
As opposed to the usual financial stress testing, the CBES will focus on the scale of adjustment that will need to be undertaken in coming decades for the system to remain resilient, identify gaps in firms’ data and risk management processes” rather than assessing their capital requirements.
Subject matter of the CBES stress testing
The CBES will use exploratory scenarios to size these future risks, explore how firms might respond to them and test the resilience of the UK’s financial system against the physical and transition risks in three distinct climate scenarios. Broadly speaking, the three proposed climate scenarios relate to taking i) early, ii) late and iii) no additional policy action to meet global climate goals.
Participating firms are asked to undertake an analysis of their most important counterparties and to assess their vulnerability to underlying physical and transition risks, i.e. climate-related risks in each scenario. Also, the counterparties’ business models and adaptation plans have to be included in the analysis of the counterparties’ contributions to climate change.
The BoE decided to exclude traded risk (i.e. risk from banks’ trading books) from the scope of the CBES, due to its dynamic nature and therefore little relevance to long duration climate scenarios. In relation to climate litigation risk, a quantitative approach for general insurers has been proposed, focused on assessing exposure in relation to seven possible adverse legal rulings, without tying these to any of the three scenarios.
Comments are sought from the participating firms on an indicative list of variables for this exercise. The proposed variables include data on national and international GDP, volatility indices of financial markets, transition risk variables such as greenhouse gas emissions by sector, energy prices, total energy consumption etc., and physical risks such as drought, flood, wildfire, storms, temperature etc. This will require direct engagement with corporate counterparties to enable the collection of data and to form an understanding of how companies are exposed to climate-related risks and opportunities.
In addition, firms are asked to calculate impacts on investments in selected asset classes and to estimate the impact for the scenarios for their total market value, when subjected to physical risks such as hurricanes or other related weather impact.
The CBES will require firms to do far more of their own modelling than the PRA’s 2019 Insurance Climate Stress Test, and a standard macroeconomic modelling exercise will not be sufficient. Firms will have to allocate appropriate levels of resources for preparing for the exercise, and need to focus on obtaining data whilst waiting for the scenario publication. and
Relevance of stress testing for disclosure obligations
The questions considered by the BoE in their climate scenario assumptions for stress testing give companies a clear indication of the criteria that will be relevant for their climate related disclosure obligations.
In view of the new disclosure obligations, companies have to be able to understand which natural catastrophe perils are to be deemed as material, and crucially, how to assess their impact on climate change and, how an assessment of materiality is undertaken.
The stress-testing exercise will identify gaps in terms of scientific knowledge, available data and tools that are needed for firms to undertake the required assessments. This is important information which will facilitate financial institutions’ compliance with their climate related disclosure obligations.
In order to align their portfolios with climate targets, firms firstly have to identify which segments of their portfolio need to be assessed as being potentially impacted by climate change, and to what to extent, and how excluding other lines of business from the analysis can be justified.
Once firms are able to assess the impact of climate risk on their balance sheets in different scenarios, they will be better able to identify any major risks.
Role of insurance
Better disclosure by companies will at the same time allow insurers to calculate their risk exposure more accurately and in turn, insurers will be able to price the more risky assets differently. Higher premiums for riskier assets help promoting more sustainable business models in the long run.
This trickle-down effect will support the increase of net-zero investors and the direction of travel for impact investing, and lead overall to more sustainability in the economy.
Whilst the CBES will be launched in June 2021, a program of early engagement with the participating firms for the June 2021 exercise has already been announced, and a draft data template for feedback will be provided in February 2021. Hopefully firms will have the resources to engage meaningfully with this exercise, despite the current COVID-19 and Brexit impacted economic climate.