The Bank of England (BoE) published its long-awaited Climate Biennial Exploratory Scenario (CBES) on 8 June 2021.
It is designed to allow policymakers to probe the resilience of the UK financial system to a wide range of risks and it is a tool to enhance participants’ strategic thinking on how to manage those risks. It aims to explore the resilience of the largest UK banks and (Nationwide), selected large insurers and ten selected Lloyd’s syndicates to the physical and transition risks associated with climate change.
The desired outcomes of the CBES are to:
- Size the financial exposures of participants and the financial system more broadly to climate-related risks.
- Understand the challenges to participants’ business models from these risks and gauge their likely responses and the implications for the provision of financial services.
- Assist participants in enhancing their management of climate-related financial risks. This includes engaging counterparties to understand their vulnerability to climate change.
The Bank intends for the CBES to be a learning exercise and it will not be used by the Bank to set capital requirements, Expertise in modelling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the Bank and CBES participants. It will also explore the vulnerability of current business models to future climate policy pathways. To be able to use the result for setting capital requirements, the Bank would need a much more robust set of data.
Participants will have to measure the impact of the scenarios on their end-2020 balance sheets, which represents a proxy for their current business models. For banks, the CBES focuses on the credit risk associated with the banking book, with an emphasis on detailed analysis of risks to large corporate counterparties. For insurers, the focus is on changes in Invested Assets (and Reinsurance Recoverables) and Insurance Liabilities (including accepted Reinsurance).
The CBES will also explore how firms intend to adapt their business models over time, and the management actions participants would anticipate taking in the published scenarios.
The CBES uses three scenarios to explore both transition risk (as the economy moves from a carbon-intensive one to net zero emissions) and physical risk (associated with higher global temperatures). The scenarios are not a forecast, they are plausible representations of what might happen based on different future paths of governments’ climate policies. They look ahead until 2050.
The scenarios explored are as follows:
- Early Action: the transition to a net-zero economy starts in 2021 and policies intensify relatively gradually over the scenario horizon. Global carbon dioxide emissions are reduced to net-zero by around 2050. Global warming is limited to 1.8°C by the end of the scenario (2050) relative to pre-industrial levels.
- Late Action: the implementation of policy is delayed until 2031 and is then more sudden and disorderly resulting in a material short-term macroeconomic disruption. Global warming is limited to 1.8°C by 2050.
- No Additional Action scenario primarily explores physical risks from climate change. Here, there are no new climate policies introduced beyond those already implemented. Global temperature levels continue to increase, reaching 3.3°C by the end of the scenario.
The CBES scenario specification builds upon a subset of the Network for Greening the Financial System (NGFS) climate scenarios. It uses the three scenarios from the six developed by the NGFS. They are produced in partnership with leading climate scientists, leveraging climate-economy models that have been widely used to inform policymakers, and have been used in key reports.
The Bank expects to publish CBES results in May 2022, following two rounds of participants’ submissions. Results might be published sooner if the Bank decides not to ask for the second round of submissions.
The scenarios in more detail
The bank of England stresses that the CBES is not a stress test in the traditional sense. It is distinct in several ways:
- Wider in scope: climate variables are provided in addition to macrofinancial variables
- Wider in participation: both banks and insurers are subject to the test
- Multiple scenarios with a longer horizon: three scenarios spanning over 30 years
- Exploratory exercise: the purpose is to develop capabilities both for the Bank and the participants
- Novel modelling approaches: very granular analysis will be needed by geography, sector and counterparty
- Not informing capital requirements: instead, it will assist the FPC’s approach to system-wide issues and the PRA’s supervisory policy
- Second round of submissions: to explore interactions between participant’s response (e.g. banks and insurers)
About transitions risks
To enable participants to assess the climate change-related transition risks the CBES provides details about
- Phase-out of fossil fuels, which is associated with changes in overall energy use as well as by changes in the energy mix reducing the carbon intensity of energy. In both the Early and Late Action scenarios, fossil fuels are almost entirely replaced by renewables in the UK primary energy mix by 2050. For example, the proportion of renewables is assessed to be 90% in the UK and 70% globally accounting for hard-to-abate steel and cement production. However, the recent news of $300bn investment in green cement production already shows how quickly assumptions can change.
- Commodity markets: In the Early Action and Late Action scenarios, producer fossil fuel prices are under downwards pressure from declining fossil fuel use, although producer ‘sell-off’ behaviour is not explicitly modelled
- In the UK, climate change is expected to increase average temperature, increase precipitation in the winter months, reduce precipitation in the summer months, and cause sea level to rise, with an increased risk of flooding. More exposure is expected to subsidence and heat waves. For example, the UK’s wettest day on record could become ten times more frequent for climatic conditions similar to those in year 10 of the No Additional Action scenario. Sea level rise also contributes to the risk of coastal flooding in the UK, with the mean sea level 0.4 metres higher by the end of the No Additional Action scenario than in the late 20th century.
- Global precipitation: Increased average precipitation rates in some parts of the world could lead to increased river discharge and inland floods. In other parts lower precipitation could adversely impact water supply and agricultural production.
- Global sea level rise leads to increased coastal flooding risk.
- Tropical cyclones can have significant impacts on physical infrastructure and supply chains via damaging wind, storm surge and excess rainfall. The rise in temperatures is expected to lead to a significant increase in the frequency of severe tropical cyclones in certain regions in the world.
- Heat waves like the one in June/July 2021 in the western US are a stark reminder that hot days are getting hotter and more frequent. The increased risk of heatwaves leads to risk widespread drought, crop failures, and wildfires and it reduces labour productivity.
- Adaptation and mitigation: flood defences and improved national responses to natural disaster can help reduce the impacts of physical risks; just as pre-emptive reductions in reliance on carbon-intensive methods of production can limit transition risks. As a general rule, when participants analyse the impact of the scenarios on specific government or corporate counterparties, only those adaptation and mitigation plans that are already being implemented and that are highly likely to be completed will be factored into headline loss estimates. The only exemption is the specific path of UK flood defences (the deterioration of the standard of protection provided by existing flood defences as the risk of floods increases) provided by the scenarios.
- Early Action: Orderly transition, modest impact of transition risks as the effects of higher carbon prices and energy costs are mostly offset by energy efficiency improvements and distributional effects. The main drivers of UK and global GDP profiles are rising carbon prices and changes in energy usage and productivity improvements Short and long-term interest rates rise gradually in the UK and in other major economies, with some of that increase reflecting the effect of the higher levels of investment needed to address risks from climate change. UK house prices grow at a somewhat slower rate than they would have done without the projected impact of climate risks in the scenario.
- Late Action: A sharp, unanticipated increase in shadow carbon prices in 2031 reduces the supply capacity of the economy. For the UK, the peak GDP impact relative to the counterfactual is around -8% in 2033 with the annual GDP growth rate settling at -2.7%. Unemployment rate peaks at 8.5%. The inflation rate rises to over 4%. The main drivers of UK and global GDP profiles are rising carbon prices and changes in energy usage, capital stranding, falling labour force participation and temporarily lower productivity. UK aggregate house prices in the scenario fall by 19% peak-to-trough in absolute terms. Equity prices also fall in the scenario, with the peak-to-trough correction of close to 20% in the UK and in the US.
- No Additional Action: The more severe physical risks in the No Additional Action scenario result in a material cumulative impact on GDP. UK GDP only grows at an average rate of around 1.4% in years 6–10 of the scenario, with the growth rate falling further to around 1.2% towards the end of the scenario. After 30 years, the level of UK GDP is around 8% below the level it hypothetically might have been in the absence of climate risks. The impacts of physical risks on GDP are even more severe globally. The main drivers of UK and global GDP profiles are falling productivity, damage to capital, supply chain disruptions and falling trade volumes. The UK inflation and unemployment rates are little changed from the counterfactual by the end of the scenario Aggregate UK house prices fall gradually relative to the counterfactual, with the cumulative impact of -22% by the end of the scenario. But some property prices are much more adversely affected. Macroeconomic uncertainty faced by households and companies increases as the physical environment becomes more hazardous and unpredictable. Measures of market volatility also trend upward in the scenario, with the VIX rising by around 50% from its 2021 level. Assuming trends at the end of the scenario are maintained, in another 30 years, UK GDP in the No Additional Action scenario would be 16% below the counterfactual level.
- Sectoral differences: The degree of exposure to climate risks varies across different sectors of the economy. Sectors relying on carbon-intensive production processes are more vulnerable to transition risks than the economy as a whole. And sectors that are highly dependent on physical infrastructure in certain areas could be more vulnerable to physical risks. This is reflected in the calibration of Gross Value Added (GVA) paths for 59 individual sectors within the CBES scenarios.
To complete the foundation for the exercise the CBES provides a detailed overview of the UK transition policies for energy efficiency of buildings and deployment of electric vehicles. To the extent that specific material policies to reach those targets have been announced, the assumptions underpinning the calibration of the CBES scenarios have been consistent with these.