- The Bank of England’s first round of climate stress tests provided useful insight, says head of climate Chris Faint, refuting criticism by ex-HSBC executive Stuart Kirk.
- While climate does not appear to be a solvency issue, it could hit banks’ and insurers’ profits hard if not managed appropriately, found the central bank.
- The Bank of England will not use these results to set capital requirements for now, but that could change.
Lenders and insurers may be relieved that the Bank of England (BoE) does not, after completing its first round of economic stress tests, view climate risk as a solvency issue requiring them to set aside additional capital. But they should perhaps not get too comfortable, as the recent climate scenario analysis findings do not paint a particularly positive picture.
Chris Faint, head of the BoE’s climate division, spoke to Capital Monitor about the central bank’s concerns. He also responded to criticisms levelled at climate stress tests by Stuart Kirk in May, the former head of responsible investment at HSBC Global Asset Management, who this week announced his departure from the firm.
The 2008 financial crisis brutally highlighted the importance of economic stress tests to prudential regulators. Central banks – with those in Europe leading the pack – are now applying them to banks’ and insurers’ preparedness for climate change, given that environmental deterioration is widely viewed as a major systemic risk to the financial system.
The goal is to establish how balance sheets and capital levels can withstand both physical risks (such as flooding, subsidence, droughts and fires) and transition risks (policy changes to facilitate the shift to net-zero emissions). Central bankers concede that such tests are far from perfect, but feel they can produce valuable insight and have been working together on the best way of conducting them.
In late May the BoE completed its first round of tests of 19 UK lenders and insurers on three policy-response scenarios over a 30-year period: no policy action; early policy action driving an orderly transition; and late policy action resulting in a disorderly transition.
The results showed that while British banks and insurers were likely to be able to absorb the costs of the transition, their profits would probably suffer and they would pass some of these costs on to consumers. The profitability hit could be as high as 10-15% if firms fail to manage climate risks properly – though the limited nature of the tests means that number could be far bigger.
The BoE concludes that the best way for banks to minimise this damage is by taking early, well-managed action to cut their own and their clients’ greenhouse gas emissions.
“In all three scenarios we’re not suggesting [climate risk] would be a solvency issue, but – and this is important – we didn’t look at all the risks. And while not a solvency issue, it is a profitability issue,” says Faint.
Assessing the risks
UK banks and insurers are making good progress in some areas of environmental risk management, the results show – for example, they have all published climate strategies or net-zero transition plans.
But they still have much to do to understand and manage such risks. For instance, few firms specified how they would manage exiting certain industries if their peers also sought to do the same, and most struggled to assess their exposure to the global rise in climate-related litigation.
Set over 30 years – out to 2051, by which point the Intergovernmental Panel on Climate Change says global temperatures are likely to rise at least 1.5°C beyond pre-industrial levels – this kind of exercise forces banks to look beyond the six-year length of a typical loan.
Indeed, HSBC’s Kirk infamously said in May that climate risk is too long-term for financial firms to be concerned about, and that central bankers – notably in the Netherlands and the UK – were among those overstating the risks posed by climate change. They have, Kirk said, inserted “a gigantic interest rate shock” into stress tests, with the aim of producing more negative results.
The BoE’s climate stress tests do not fit that description, argues Faint. “It is quite conceivable that we could have calibrated a much gloomier… scenario,” he says. But the projected bank losses – which are based on the elements of banks’ businesses covered by the test – “were actually quite modest when spread across the 30-year horizon”.
“That is not to say we do not think there is a risk that losses will be much larger,” Faint adds. “They may… be underestimated due to banks’ fairly nascent approaches to modelling these risks at present.”
Lack of data
In any case, the BoE stresses that the results are not conclusive. Given the scale of the exercise, they are somewhat limited in approach and based on banks’ end-2020 balance sheets. The analysis did not look at trading books or individual firms’ exclusion policies and is constrained by the lack of available data.
One somewhat obvious – but important – finding from the exercise is that better policy certainty from governments would help banks and regulatory authorities considerably in forward planning.
“The real challenge is that financial services firms are representative of the real economy, so if industries in the real economy don’t know what their transition pathways are, it’s really hard to know the impact on banks and insurers,” says Faint.
Over time this will change – the UK government announced its desire to mandate transition plans across the economy, without yet setting a time frame for this.
In the widespread absence of transition plans among corporates, the stress test exercise was heavily labour-intensive. Banks had to approach their counterparties to understand their expectations under the various scenarios.
Ultimately, there is a huge shortfall in knowledge and understanding in this area across the economy, found the BoE. One-third of companies globally have already produced a transition plan, but these are almost all large, listed businesses, according to CDP, a non-profit that helps companies disclose their environmental impact.
Stress tests set to evolve
The BoE will eventually publish institution-specific results from these tests, as climate change poses different risks to every company and financial institution. But it will not do so for some time, mainly because this was an initial exploratory exercise. After all, such results can have a shareholder impact, Faint says, and the huge variation in judgements and available data means comparisons would not be that helpful at this early stage.
While the BoE’s core aim was to consider the impact of climate risks on financial stability, the exercise produced all kinds of important insight that could inform other areas of government policy, says Faint.
For instance, under the most extreme scenario, 7% of currently insured households would be unable to secure property insurance. That is a “huge number”, Faint says, and the central bank has flagged this issue with government.
The BoE does not plan to use the results to set capital requirements, but they will inform how it might do so, says Faint.
While the modelling suggests climate risk is not a solvency issue, banks and insurers should not rest on their laurels. The BoE concluded that a well-timed and steady transition, starting without delay, will be essential to get to net zero by 2050.
Capital Monitor is hosting the Webinar series, Making Sense of Net Zero. Find out more information on NSMG.live.