CBES highlights the stark cost of climate risk inaction on banks’ bottom lines
In May 2022, the Bank of England (BoE) published the results of its Climate Biennial Exploratory Scenario (CBES) to evaluate the potential impact of the UK’s transition to net-zero carbon emissions by 2050. While admitting that expertise in modelling climate-related risk is in its infancy, the exercise set out to explore the potential risks posed by climate change to UK banks and insurers, whilst searching for the next steps for the industry as well as future CBES exercises.
So what did it tell us about the anticipated impact of climate change on the banking sector?
The CBES exercise is designed to illustrate the possible pathways of a net-zero transition using three scenarios: Early Action (EA), Late Action (LA) or No Additional Action (NAA). Each scenario is based on the Network for Greening the Financial System’s (NGFS) climate scenarios which explore transition and physical risks, to varying degrees. A selection of the UK’s 7 largest banks and 12 insurers participated in the study. The seven banks, who collectively represent around 70% of UK bank lending to UK households and business, were asked to estimate the performance of their current lending/investment portfolios under each of the given scenarios.
The transition for EA is ambitious, starting quickly with a steady intensification of policies and carbon taxes across the 30-year period. Over time banks will begin to see productivity gains from their investments in green technology and, having initially risen, global temperatures will eventually fall.
In the LA scenario, policy measures are delayed by a decade and therefore sudden, harsh, and disorderly. As a result, short-term macroeconomic disruption is likely; for example, “UK unemployment rises to 8.5% and the economy goes into recession.” Additionally, global temperatures rise and do not subsequently fall.
Finally, the severe NAA scenario depicts what could happen if no additional action is taken, the absence of any transition policies leading to global temperatures rising significantly. Subsequently, there will be permanent and adverse changes to our ecosystems, macroeconomic uncertainty, and UK equity prices would be “respectively just under 20 and 25% lower than they might otherwise be.”
What were the results?
Across all three scenarios, inadequate preparation and response by banks could lead to a “persistent and material drag on their profitability.” More specifically, the report looked at credit losses banks could face across each scenario. Interestingly, LA saw the greatest measurable losses for participating banks, “equivalent to an extra c.£110 billion of losses”, with a staggering 40% of that being realised in the first 5 years of transition. A faster, less orderly transition could also leave certain sectors behind if swathes of lending are withdrawn without time to prepare.
Significant corporate losses were also realised through the NAA scenario, despite the BoE noting it was only able to capture a subset of the losses, which would continue to build and persist far past the 30-year horizon. Commentary in the report suggests that some banks were unable to adequately assess the physical risks arising in this scenario, with impairment estimates around 40% lower than those re-calculated through BoE models. This correction would bring losses from the LA and NAA scenarios to around the same levels – a key point of reflection for participants.
In line with that finding, the BoE suggests that one fundamental problem faced when tackling climate-related risk is availability of relevant data and – more fundamentally – knowing what data to collect. This mutes banks’ ability to accurately quantify climate-related risks and subsequently account for those risks in their business decisions. To resolve this the BoE recommends prioritising investment in internal data and modelling capabilities to improve firms’ climate risk assessment capabilities and reduce their financial risk exposure.
Additionally, reducing deficiencies in climate data would help strengthen banks’ risk management reporting frameworks, although the BoE noted strong progress in this area already, with many participants having effectively integrated climate risk into their existing frameworks with senior level accountability.
Those involved also made good progress in identifying which portfolios were most sensitive to climate risk, but once again faced challenges in accurately quantifying that risk. Because of their unique positions, banks will need to engage with companies across all sectors to fully understand what has, will, and can be done to mitigate climate risks.
Finally, outcomes from the EA offer a far brighter picture than those under the NAA and LA scenarios, and demonstrate the value that decisive action and effective climate risk management could have on banks’ bottom lines. Specifically, banks’ projected total losses with early action were 10% lower than with late action. The business case for banks to support climate action is undeniable.
So what should banks do about it?
In response to such a stark warning for the industry, we would recommend firms take immediate action across five key elements of their climate risk management framework:
Modelling and Data Capabilities: A common theme in the submissions was the existence of data gaps and weak modelling capabilities. This can lead to an incomplete understanding of climate risk exposures in the balance sheet. Banks should look to better understand what data they need, and how they can capture and model it, to help manage their full climate risk exposure. BCS helps design and implement data management solutions to help drive performance through analytics.
Business Models: Banks should assess how they regularly update climate policy and integrate it into their business models. BCS helps insurers embed climate risk management strategy into their business models to ensure they meet their goals in working towards a net-zero economy.
Improved TCFD Disclosures and Risk Frameworks: The underlying theme in the study is that the banks are still yet to fully understand the full extent of climate risks they face; material risks outside of the scope of CBES are just as significant as those considered. BCS helps firms develop more robust processes to identify, disclose and manage their climate risk exposure.
Capital Requirements: Though not directly addressed in CBES, firms should not ignore how the results could affect their solvency. Firms need to assess how climate change may impact expected losses on their books of business, particularly on books of business that are exposed to the impacts of the environment, i.e., physical risks. BCS helps firms to develop more effective forward-looking capital and financial planning systems and processes
Senior Management ESG Training and Awareness: Enables adequate preparation for senior management oversight and strategic planning, highlighting industry trends and taking into consideration the business model of the organisation. BCS develops and delivers ESG executive training programs.
The CBES highlights the risk of climate inaction to the banking sector; but it also offers some hope. If banks enhance their climate-risk management practices now, they can play a key role in driving a more timely transition to a net zero economy. As the differing outcomes between the three CBES scenarios show, this could shield not only the banking sector from the most devastating impacts of climate change, but the whole world.