On 15 October 2018, the Bank of England’s Prudential Regulatory Authority (PRA) published a consultation paper on “Enhancing bank’s and insurers’ approaches to managing the risks from climate change”. The paper seeks views on a Draft Supervisory Statement which sets out the PRA’s expectations as to how banks’ and insurers’ should approach managing the financial risks of climate change. The paper draws on findings in the PRA’s 2018 report “Transition in thinking: The impact of climate change on the UK banking sector”, which surveyed 90% of the UK banking sector representing over £11 trillion in assets. It also draws on the PRA’s recent engagement with the insurance sector, which built on its 2015 report “The impact of climate change on the insurance sector”, broader findings from the Bank of England’s climate change work, and “international liaison with other regulatory bodies”.
Climate-Related Financial Risks – Physical, Transition and Legal Liability
The PRA identified two primary categories of climate-related financial risk for regulated firms – physical risk and transition risk. Physical risks derive from specific weather events as well as longer-term climate shifts, and encompass direct impacts such as property damage leading to impaired asset value or even sovereign risk, and indirect impacts such as supply chain disruption. Transition risk arises as markets shift towards a low-carbon economy, and derives from regulatory and policy change, disruptive technologies, and new business models which could result in adjustments to the value of companies, assets or investments. For banks and insurers, these risks manifest in multiple ways, including as increasing underwriting, reserving, credit, or market risk for firms.
Legal liability risks that are consequential to physical and transition risks should also not be ignored. In recent years, the extent of climate-related litigation has increased. In addition to claims being brought by parties affected by climate change against those whom they hold liable, claims have been brought against companies for failure to mitigate, adapt to or disclose climate-related financial risks. Such legal liability risks can impact a company’s value and/or lead to claims under insurance policies (e.g. public liability, directors’ and officers’, or professional indemnity insurance policies).
The PRA notes that there are distinctive elements to climate-related risks which make them difficult to anticipate: they span multiple sectors, regions and businesses, have potentially irreversible consequences, and an uncertain timeframe in which they may be realised.
The PRA also notes two paradoxes in managing climate change risk: it may be too late to stabilise the atmosphere once it becomes a clear and present danger to financial stability, however, a too rapid shift towards a low-carbon economy could itself materially damage financial stability. The PRA therefore calls for these risks to be managed in an orderly, effective and productive manner, to avoid a “too little, too late scenario”. The PRA warns, however, that the window for such an orderly transition is “finite and closing”.
The PRA’s Desired Outcome
The PRA’s desired outcome is that firms take a “forward-thinking, strategic approach” to managing climate-related financial risks. According to the PRA’s banking and insurance sector reports, few firms currently take such an approach. The majority approach climate-related risk from either a Corporate Social Responsibility (CSR) perspective or assess the risk within a too-short timeframe of three to five year. A significant number of firms accordingly may need to review and possibly overhaul their climate risk strategies.
The Draft Supervisory Statement sets outs the PRA’s proposed expectations
- That firms embed consideration of financial risks from climate change in their governance arrangements (including, clear roles and responsibilities at board level and, where appropriate, evidence of how firms monitor and manage such risks);
- Incorporate such risks into their existing risk management practices (such as including material exposures in the Internal Capital Adequacy Assessment Process or the Own Risk and Solvency Assessment), and provide information on exposure to board and relevant management committees;
- Use scenario analysis (assessing short and long term outcomes) to inform strategy setting and risk assessment; and
- Develop an approach to disclosure of such financial risks that takes into account the interaction of risk categories as well as their distinctive elements. Disclosure should be considered in the context of existing risk disclosure requirements such as under the Capital Requirements Regulation, Solvency II, and the Companies Act 2006. The PRA also expects firms to engage in wider initiatives such as the Financial Stability Board’s (FSB) Task Force on Climate-Related Financial Disclosures (TCFD).
The PRA has intentionally set high-level expectations in order to allow firms’ to continue to develop and mature their practice regarding climate-related risks as expertise develops over time. The PRA also expects responses to be proportionate to the nature, scale and complexity of a firm’s business.
One clear and consistent message from the PRA, however, is the need for engagement and accountability at both board-level and the highest level of executive management, as well as clear individual responsibilities for relevant senior manager function holders.