Aim to provide supervisors with a common starting point for analysing climate risks under different scenarios
The Bank of England (BoE) has set out a comprehensive stress test for financial services companies to explore and put metrics around the financial risks posed by climate change.
The Climate Biennial Exploratory Scenario (CBES) uses three scenarios of early, late and no additional action to explore the two key risks from climate change: the risks arising from the significant structural changes to the economy needed to achieve net zero emissions – ‘transition risk’ and risks associated with higher global temperatures – ‘physical risks’.
It is the first time BoE is testing both banks and insurers to capture interactions between them and understand the risks presented by climate change across the financial system.
Andrew Bailey the governor of the Bank of England said: “It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks.
”It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”
Sarah Breeden, the Bank of England executive sponsor for climate change added that the stress test would “provide central banks and supervisors around the globe with a common starting point for analysing climate risks under different future pathways.
”Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system.
”Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today. I encourage all firms, not just those participating, to engage in and learn from this exercise.”
The Bank expects to publish the CBES results in May 2022.
The objectives of the exercise are to:
- Size the financial exposures of individual firms and the financial system to their end-2020 balance sheets: this will shine a light on risks that are currently opaque;
- Understand business model challenges and likely responses to these risks: this will highlight where action may be needed and any implications for the provision of financial services, and
- Improve firms’ risk management and prompt a strategic view: this includes building capability, both amongst participants and within the Bank. The exercise will also encourage participants to engage their largest counterparties to understand their vulnerability to climate change.
The CBES is an exploratory exercise. It will not be used by the Bank to set capital requirements. Instead, participants’ submissions may inform the Financial Policy Committee’s future approach to system-wide policy issues, and the Prudential Regulation Authority’s (PRA) future supervisory approach.