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Counting the cost of climate change

Zsuzsanna Schiff explores the 2021 biennial exploratory scenario on the financial risks from climate change and ICAEW’s response to it.

In December 2019 the Bank of England (BoE) published a discussion paper (DP) on the 2021 biennial exploratory scenario (BES) on the financial risks from climate change.

The proposal, if it goes ahead would mean that large UK banks and insurers would have to perform a stress tests to provide the BoE with a comprehensive assessment of the UK’s financial system’s exposure to climate change related financial risks. This would complement the annual cyclical stress tests and would be run every other year. Of course, insurers must already include these risks in their 2019 stress test and the lessons learnt from that exercise were drawn upon.

The proposed framework would provide three climate scenarios (early, late and no additional policy scenarios), test both banks and insurers together and use an extended 30-year modelling horizon. In addition, consistent macro-financial variables would be layered onto the climate variables to enable firms to model the impact of the scenarios. This would largely be based on the assessment of the vulnerability of individual counter-parties.

The desired outcomes of the BES are to:

  • To size the exposure of the participating firms and the financial system to climate change related financial risks
  • Understand the challenges participants face and
  • Assess participants in enhancing their management of these risks

Even the final design of the exercise presents many challenges. Performing it within the proposed time frame will be very difficult. The BoE sought feedback to assess how feasible the exercise was thought to be and how robust the results could be expected.

The DP provides further details of the proposed framework and we expect that banks and insurers used this opportunity to let the regulator know of their specific challenges. These will be different for each and every one of them depending on their readiness, capabilities, resources and own views of the physical, transitional and in insurance liability risks.

At ICAEW we are very supportive this initiative although do realise the enormity of the task. For BES firms will need a whole new thought process which is fundamentally different from the regular stress testing. It will be very different to even appreciate the time scale. However, it is important to remember that sudden policy and regulatory changes could significantly affect the “normal” 5-year business planning horizon.

In our response to the DP we have lauded the BoE for consulting relevant shareholders early enough and repeatedly planning so at different stages of the stress. This will help design the test in a way that it would provide helpful information and assist institutions in managing and mitigating these risks. This should enable both the BoE and the financial institutions to use the BES as a learning exercise.

However, in order to fulfil the role that the financial services industry has in servicing UK households and businesses, awareness of risks associated with the produced, social, human, and natural capital stocks and flows that generate a healthy economy, is essential. A vision must be developed that not only gazes further, but also includes the dynamics of the broader system.

Interactions between banks and insurers will be assessed in the 2021 BES, with a view to achieving the beginnings of a system-level approach. The introduction of these bold measures provides a great opportunity to explore the additional inclusion of nature-related financial risks in a timely manner. These risks (for example, effects of natural capital stock and flow degradation, including that of land and soil, deforestation, biodiversity loss, nutrient accumulation and air pollution) bear similar characteristics and carry similar impacts to climate change. They also highlight the financial services’ dependency on natural resources, human resources, and other underrepresented forms of capital, and capital flows.

It is essential for the UK financial services industry to understand the size and extent of its exposure to global systemic risks. This must look beyond only climate change exposures and look to include all financial industry risks exposed to natural, social, human, and financial impacts and dependencies.