Every year the Bank of England (BoE) publishes its thematic findings from the previous year’s written auditor reports. It offers an excellent opportunity to benchmark your performance against your peers, in areas of regulatory concern. Last year’s focus was on expected credit loss under IFRS 9 and accounting for climate risks. This was a key topic in the BoE’s recent report on climate-related risks and the regulatory capital framework, where it was highlighted as a capability gap for firms across the sector.
Climate risk can lead to material misstatement of finances
In the previous year’s thematic feedback, the BoE highlighted the risks around material misstatement in firms’ balance sheet valuations and asked auditors to review this area in relation to climate risk. The findings generally show good progress against climate risk assessments, governance and data, and auditors didn’t flag any specific risks of material misstatement in relation to climate change. This may be due to uncertainty over the longer-than-usual time scales for climate risk to crystallise, making it harder to identify risks of material misstatement.
Feedback from auditors noted the expected credit losses (ECL) were difficult to assess in this space due to:
- limited climate risk data available to management to assess exposures
- limited climate risk data available to auditors to substantiate the impact on balance sheets
- immature controls around climate data sources and use of proxies.
Some firms were further ahead than others and were looking at adapting economic scenarios for accounting estimates to include climate risks. The BoE encourages all firms to develop detailed plans for including climate risk impacts on their balance sheets moving forward, making sure accounting practices continue to reflect the risk management landscape.
Governance and financial reporting risk assessments
Looking across the auditors’ reports, it appears that firms are beginning to understand how climate risk relates to their balance sheet and future financial performance, with a senior team member now responsible for this area. That said, it’s still not translating onto the balance sheet or existing financial reporting processes.
As with anything climate-related, the lack of data is proving problematic. With the exception of ECL calculations, firms were mostly using qualitative data in their climate risk analysis. This includes risk assessments for financial reporting and audit committee work on the potential for material misstatement.
The sector is still developing best practice for climate risk data and modelling, and auditors have flagged that improvements may take years. But the BoE has seen few plans to build this capability or to understand the limitations of the current approach.
To improve in the space, the Bank of England suggests four areas for review:
1 Make sure climate risk governance processes and responsibilities are clearly embedded into the financial reporting function
2 Increase the use of quantitative analysis in climate risk assessments
3 Ensure regular reports to the audit committee include quantitative analysis climate risk and its impact on balance sheet valuations
4 Develop management information to improve oversight of data collection and modelling, and to assess the impact of limitations in this area on balance sheet valuations
Forward-looking climate-related data
As noted, the lack of quantitative data was a real concern, and this is the primary focus for this year and beyond. In the absence of clear climate risk data, many firms used proxies effectively, but this isn't a long-term solution.
There was generally a fragmented approach to data, with some financial reporting functions not making full use of climate-related data available to other parts of the business. Similarly, firms could improve data quality controls – these were typically manual controls and less robust than most financial reporting processes. As new data models come into use, firms will need closer coordination between climate risk teams and the financial reporting department.
The Bank of England suggests three areas for improvement:
1 Centralise climate risk data processes to make sure it is available for use in balance sheet valuations
2 Improve data controls including greater automation
3 Monitor data quality, and set risk appetite and targets to reduce proxy and unverified data
Climate risk and expected credit losses
Firms have made progress to identify key loan portfolios that could be affected by climate risk, and climate risk assumptions that may affect ECL. But there were no subsequent changes to ECL methodology or calculations. Finance reporting teams tended to review the adequacy of provisions for sector-specific risks instead, but the quality varied by firm and across different portfolios.
Corporate lenders have invested in training to help identify and assess climate risks, but this didn’t translate to a change in guidance in loan-level credit reviews. Retail lenders were starting to analyse the severity of specific climate risks, including the impact on property prices or borrower income.
Climate risks weren't included in significant increase in credit risk (SICR) assessments, and both retail and corporate lenders tended to focus on isolated risks in relation to probability of default (PD) or loss given (LGD). Ideally, the Bank of England want to see the impact on both, or inclusion of secondary impacts such as energy prices.
Firms used the results from the Climate Biennial Exploratory Scenario (CBES) in their risk assessments, but they didn’t include a range of climate scenarios in ECL calculations – making them inherently limited in their outlook. Ideally firms could compare IFRS 9 with CBES scenarios, or analyse how CBES losses transform into ECL losses.
Key areas for improvement:
- Identifying the climate risks that could influence ECL in the most sensitive loan portfolios
- Making greater use of quantitative analysis to assess the climate risk impact on ECL and significant increase in credit risk (SICR) at a portfolio level
- Improving data and models to factor climate risks into loan-level ECL estimates
- Working out how to include climate risk drivers into the scenarios and weightings used for ECL calculations, and how to review this at the second line of defence
Quantifying the impact of climate risk
On balance sheets, firms typically used qualitative analysis to identify the financial areas most impacted by climate risk. To improve, specific quantitative approaches would beneficial, such as:
- making the link between plans to manage climate risk and the real-world impact on profit forecasts
- assessing the fair value of long-dated level 3 instruments to counterparties that have high exposure to climate risk.
Firms don’t currently see climate change to be a material risk to the balance sheet so they haven’t updated their accounting policies. But many firms did update them to include new ESG loan products, mostly using amortised cost accounting which needs to be monitored for market consistency in the long term. The BoE also highlights the need to track exposure to ESG-related instruments – for potential impact on profitability or interaction with credit risk management.
Key areas for improvement:
- Greater quantitative analysis for balance sheet valuation line items
- Better monitoring of climate risk processes informing balance sheet valuations
- Making sure climate risk and ESG products are factored into accounting policies
Accounting for climate risk is an emerging field and it will take time for balance sheets to accurately reflect firms’ exposures. Addressing the data challenge is crucial, and firms need to gradually move away from unverified and proxy data to more closely monitored and controlled data sources. A greater reliance on quantitative data will allow for better modelling and more accurate valuation processes.
For insight and guidance on climate risk data and accounting practices, contact Rashim Arora.