Climate-related financial risks: are banks and insurers risk ready?

Climate-related risk is increasingly a focus of governments and regulators across the globe. Two UK financial services regulators have now published commercially significant consultations setting out their proposed expectations of regulated firms in dealing with the material financial risks of climate change. These have been launched at a key time; coming hot on the heels of the latest International Panel on Climate Change (IPCC) report on the challenges and opportunities associated with reaching the Paris Agreement goals and just prior to the 24th session of the Conference of Parties to the United Nations Framework Convention on Climate Change (COP024).

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.

In October 2018, the UK’s Financial Conduct Authority (FCA) published a discussion paper on “Climate Change and Green Finance” which is focussed on consumer protection but also relevant to the UK’s wider financial services market. In producing the paper, the FCA also worked closely with domestic and international regulators, as well as the UK Government, industry and experts in the field of sustainable finance.

Climate-Related Risks – A Particular Focus on Transition Risk

The FCA’s paper offers similarly strong warnings of the material risks – physical and transition – that climate change poses to financial markets and the institutions that the FCA regulates. The FCA’s particular focus, however, is on the opportunities and risks of the ongoing transition to a low-carbon economy.

The FCA warns that adequate disclosure of climate-related financial risks can have an impact on the value of long term investment decisions. However, it cites with concern various reports, including by the TCFD, which identify inadequate disclosure by companies of the financial impact of climate change and the resilience of their strategies under different climate-related scenarios, and also a lack of detailed, consistent asset-level data on climate-related value growth or attrition which makes it difficult to identify potential stranded assets. The FCA highlights particular risks in the pensions sector (given the long-term nature of pension investments) and the insurance sector which is responsible for investments of £1.9 trillion (equivalent to 25% of the UK’s total net worth).

The FCA stresses that asset managers and other financial services providers of investee companies necessarily have to consider the effects of climate change on valuation of underlying investments, and may also take this into account as part of broader considerations of sustainability.

The FCA’s Discussion

Significantly, the FCA is seeking views on the introduction of a new requirement that financial services firms (including banks, insurers and asset managers) report publicly on how they manage climate risks to their customers and operations. This reporting would reflect the risks in the relevant financial sector within which a firm operates. The FCA is also seeking views on how this might be structured and who might be required to compile such a climate risk report. The FCA sees an opportunity to build on the work of the TCFD to help organisations, including firms, manage the transition to a low-carbon economy and encourage the financial services industry to consider the impact of climate change.

In addition, the paper identifies three areas requiring greater regulatory focus from the FCA

1. Whether greater encouragement is needed to ensure issuers of securities give investors appropriate information when securities are issued and on an ongoing basis. It offers an example of requiring companies with premium listed equity shares to provide a statement to investors explaining whether or not they have followed the TCFD recommendations in preparing their disclosures, and if not, why not. Also, whether issuers require greater clarity as to what is expected of them. The FCA notes that it is consulting on guidance to issuers on how the current regulatory regime might be interpreted to apply to climate-related risks, which would reflect the FCA’s view that existing disclosure obligations would capture the reporting implications of climate change on a business where it is material to the companies’ prospects;
2. Addressing the recommendations of the Law Commission’s report on Pension Funds and Social Investment by consulting on rule changes and guidance on assessing and reporting on financial and non-financial factors including climate change; and
3. The steps the FCA is taking to boost innovation in specialist green products and to ensure these markets work well and deliver good outcomes for all consumers. It sees two potential ways to further enable innovative models in green finance and ethical investing. Firstly, building on its 2018 proposal to create a global regulatory sandbox utilising its collaboration with the Global Financial Innovation Network (GFIN) to provide more efficient ways for innovative firms to interact with financial services regulators and navigate between countries when seeking to scale up ideas. GFIN will also create a new framework for co-operation between regulators on innovation related topics. Secondly, GFIN could also be used to explore, share ideas and experiences (including barriers to market) and/or collaborate on green finance.

The deadlines for responding to the PRA and FCA consultations are respectively, 15 and 31 January 2019. In the meantime, the PRA and FCA will be establishing a joint Climate Financial Risk Forum, involving senior staff from industry and technical experts. This forum will seek to advance financial sector approaches to managing climate-related financial risks and support innovation for financial products and services in green finance.