Capturing and quantifying climate risk isn’t easy. With so many unknowns, and longer-than-usual time horizons, it’s difficult to assess how the regulatory capital framework for banks and insurers should adapt to safeguard against these risks. The Bank of England’s 2021 Climate Change Adaptation Report (CCAR) found that the framework captures some climate risks, but a further review building on this work has found both capability and regime gaps that need addressing to ensure a safe and sound financial system.
First, let's define what capability and regime gaps are.
Capability gaps refer to a firm's ability to identify and measure its climate risks. Gaps may be due to limited climate risk data or modelling techniques, or broader challenges around scenario analysis, accounting or regulatory valuations.
Regime gaps refer to the design or use of the regulatory capital framework itself. For example, the macroprudential framework doesn’t explicitly consider climate risks and the microeconomic framework typically uses historic data to assess short-term risk. This is at odds with unprecedented climate risk and its longer-than-usual risk horizons.
In the short term, the Bank of England is looking at how to reduce capability gaps in climate risk management. Financial losses can either be expected and controlled through good risk management frameworks, or unexpected and managed through the regulatory capital framework. It’s essential that all firms meet regulatory expectation as outlined in SS3/19, to effectively identify and plan for expected losses. This will put firms in a better position to manage the impact of unexpected losses due to climate risk.
In its 2022 Dear CEO letter, the Prudential Regulation Authority (PRA) noted that, despite good progress, all firms need further action to improve their risk management framework. This includes work on governance, embedding climate risk management, scenario analysis, data and disclosures. The PRA recognises that it will take time to implement change but firms need to set themselves ambitious goals and keep moving toward them.
Firms are also responsible for capital adequacy assessments, through the Internal Capital Adequacy Assessment Process (ICAAP) or the own risk and solvency assessment (ORSA). These must include adequate information to support conclusions, including details of methodologies, assumptions or expert judgements. They should also explain any areas of uncertainty, and how the firm has capitalised against material risks. To achieve this, firms need good risk assessment and valuation processes to understand their counterparties’ climate risk, and financial and capital positions of the firm’s investments. Good climate risk accounting processes will help the sector develop greater reporting process, boost comparability and improve supervision.
Climate risk may crystallise through traditional channels, such as credit or market risk. But there are some areas where climate risk presents unique challenges for the regulatory capital regime.
Lack of historical data makes it difficult to quantity risks, validate models, and calibrate capital requirements. Over time, firms will build more data to model for physical risks but transition risks will often be one-offs that will always be tricky to model for.
Climate risk disclosures aren’t standardised across all businesses, covering all sectors. This makes it hard to assess the extent of counterparty risks and establish more informed risk assessments to inform supervision.
These rely on consistent accounting practices. If firms don’t have good practices in place to estimate expected losses for climate risk, capital resource requirements will need to go up to cover unexpected losses.
Scenario analysis and stress testing are useful tools to identify climate risks and dependencies. However, the Bank of England will give firms time to develop their capabilities before another undertaking like Climate Biennial Exploratory Scenario (CBES). In the medium-term, it will look at how specific climate scenarios can inform stress testing for the wider banking system.
Given the longer-than-usual time horizons for climate risk, the CCAR questioned if the one-year time frame for setting capital was still appropriate. The Bank of England believes it is, as the microprudential capital framework specifically targets near-term unexpected losses while considering long-term risks. Extending it would require a fundamental change to the framework with limited benefits. In turn, the macroprudential framework should address systemic risks, which may crystallise over a longer time frame, and the Bank of England highlights the need for further work to identify gaps in this regime.
As the Bank of England continues to assess regime gaps, individual firms need to focus on closing capability gaps. This includes work on governance, climate risk management, climate risk strategy, data, disclosures and effective scenario analysis. Firms also need to work on climate risk accounting, making sure processes are effectively governed and meet regulatory expectations.
For more insight and guidance, contact Rashim Arora.
