Climate change and financial risks
Late last year, the Prudential Regulation Authority (PRA) released its consultation paper 23/18 entitled ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change’ (the Consultation Paper), along with a draft supervisory statement (the draft SS) on UK insurers’ (and banks’) approaches to managing the financial risks from climate change.
In the Consultation Paper, the PRA identifies the financial risks from climate change as arising primarily by way of physical, transitional and liability risk factors. Until recently, the focus has, perhaps unsurprisingly, been weighted toward the more obvious physical risks associated with climate change. However, the Consultation Paper comes at a time when there is increasing consensus that climate change will have a significant impact on the financial system, including insurers, in the near, and long-term, future.
The unique challenges posed in relation to the financial system arise from a number of factors identified in the Consultation Paper, including:
- The potential for large-scale impact from the risks
- The uncertain and long-term time horizon for the full impact of financial risks to crystallise
- The high likelihood that some form of financial risk will materialise
- The strong correlation between actions taken today and the magnitude of any future impact.
The urgent actions required to arrest potentially catastrophic global warming are brought into sharp focus in both the 2015 Paris Climate Change Agreement and, more recently, the report of the UN Intergovernmental Panel on Climate Change. The transition required will create a range of economic risks for businesses and their boards, who owe responsibilities to stakeholders, including shareholders, to understand, assess, mitigate, adapt to and report on these risks.
The recent report from the Commonwealth Climate and Law Initiative, ‘Directors’ Liability and Climate Risk: United Kingdom – Country Paper’, highlights the potential exposure for companies and directors to legal liability in relation to:
- A company’s contribution to anthropogenic climate change, as stakeholders find more innovative ways to claim from corporations and their boards whose activities may have contributed to climate change.
- Failure to adequately manage the physical and transition risks, in particular arising from falling investor returns from a shift away from investments in fossil fuel producing and other high emission entities.
- Inaccurate, misleading or fraudulent reporting.
The latter is perhaps best illustrated by the 2016 litigation against ExxonMobil by shareholders alleging it failed to appropriately price its climate-related risk and the regulatory complaint made by ClientEarth against three insurers for allegedly failing to properly disclose climate-related risks in their annual reports.
In that context, it is self-evident that insurers must treat climate risk as a material financial risk, rather than a discrete moral imperative. This is particularly so where social and judicial attitudes toward contributors to climate change are hardening and the current trajectory suggests that directors will be held to increasingly stringent standards in relation to their assessment and management of climate risk. As such, oversight of the financial risks from climate change and responsibility for the strategy, targets and risk appetite relating to those risks should be considered and implemented at board level.
The draft SS builds on previous work undertaken by the Bank of England, the Financial Conduct Authority (FCA) and the PRA in this area and recent engagement with the banking and insurance sectors. It sets out the PRA’s proposed expectations on how UK banks and insurers address climate risk in four distinct areas:
- Appropriate governance
- Risk management
- Scenario analysis
The PRA’s primary concern is to ensure that banks and insurers are not only improving their approaches to managing climate risk, but doing so in a strategic manner that takes into account how their actions today affect financial risks in the future.
Importantly, the PRA recognises the significant disparity in the level of maturity of firm’s responses to climate risk and that, in those circumstances, industry practice in this area will take time to develop and mature. To that end, greater collaboration between regulators and insurers in this area is to be welcomed, although further work will be required to improve the quality and quantity of environmental, social and corporate governance data available before many of the recommendations in the draft SS will be capable of meaningful implementation. In order to maintain the momentum in this area, the PRA and FCA have established a Climate Financial Risk Forum, which will involve senior industry members and technical experts and is due to meet for the first time early this year.
Insurers will also be keen for the PRA to have continuing regard to international developments in this area (particularly those in the EU), to avoid a multiplicity of regulatory requirements impacting upon insurers’ preparedness and ability to comply.
While the climate risks faced by insurers are significant, it must also be recognised that they are also uniquely placed to seize opportunities and bring about positive change through innovation, which in many cases is already occurring. This includes:
- Increasing insurance penetration to mitigate economic losses caused by climate-related disasters.
- Adjusting third party liability policies for environmental liability, directors’ and officers’ liability and other professional liabilities to cover liability associated with climate change losses.
- Offering lower premiums to businesses adopting ‘green’ policies.
- Increasing the availability of policies covering green energy sources and the increasing utilisation of products such as parametric and carbon dioxide-related insurance.
The Consultation Paper is a further indication that UK regulators are taking climate risks to the financial system seriously and expect insurers to do likewise. There is no doubt that this will be an issue of increasing importance in the year to come and we will provide further updates in relation to the PRA consultation (and broader issues) as they develop.
Related items: Climate change: risks in the spotlight