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British FIs warned on climate change impact

Thursday 26 May 2022

British financial services need to pay close attention to the impact climate-related financial risks.

Deputy Governor for prudential and chief executive officer of the prudential authority Sam Woods said that Regualted entities need to understand on a ‘granular’ level what climate change related financial risks could mean for their balance sheets now and in the future.

“Should climate risk be captured in capital requirements? In one sense, the answer is an obvious yes. Climate change will inevitably drive losses for banks and insurers – even in a scenario where governments around the world take swift and prompt action to bring us to net zero.”

Woods explained that form a prudential level,  it is important ensure that financial system can withstand the impact of climate change risk, which, he said raised the question about current capita; regimes.

For him hat mean that there two that need to be addressed:

  • Regime gap: the current scope, design  and methodology of the capital frameworks do not adequately cover climate change related financial risks
  • Capability gaps: the risks posed by climate change relate financial risk is not covered by historical data
Woods’ call to the British financial  sector comes around the same time as the Climate Biennale Exploratory Scenario (CBES) that began last year.

Which showed that the while banks and insurers were making  good progress climate change -related risk management there were some areas that  needed improvement:

  • the need for more data on, and understanding of, customers’ current emissions and transition plans. This can include looking through complex chains of financial relationships between clients and counterparties to see the underlying emissions.
  • The need to invest in modelling capabilities and doing more to scrutinise data and projections supplied by third parties.
  • The need for some firms to consider more deeply how they would respond strategically to different scenarios, including thinking through the implications of different paths for climate policy.
New Zealand taking a stronger approach
 Just earlier this month the Reserve Bank of New Zealand (RBNZ)
reaffirmed its support for the External Reporting Board (XRB) which is building a tool to help understand and mitigate climate-related financial risks.
Late last year, the Australia  Prudential Regulatory Authority (APRA) published a regulatory guide for
climate change financial risks.

At the time of the release APRA chair Wayne Byres spoke in the context previous government’s Net 0 by 2050 commitment.

“Most APRA-regulated entities recognise the potential challenges of climate change, such as future changes in consumer and investor demand, emerging technologies, new laws, or adjustments in asset values, but they don’t always have a good understanding of how to respond. CPG 229 is a direct response to their request for more clarity about regulatory expectations and examples of better industry practice.”

But Byres acknowledged then that the practice guide did not actually impose any new obligations on the APRA-regulated entities.
Despite the work done by the Bank of England and the CBES Sam Woods indicated that there was still more work to do and questions to answer:

  • To the extent that climate change makes the distribution of future shocks nastier, that could imply higher capital requirements, all else equal. So, a key judgement will be: are current capital levels sufficiently high to guard against unexpected shocks during the transition?
  • Even if capital levels are appropriate in aggregate, which does not mean that the capital is held in the right places. As we have seen, some of these risks are highly concentrated in particular sectors. A second key judgement will therefore be: does the framework of capital requirements capture climate risk at a sufficiently granular level?
  • We also need to ensure firms have the right incentives to continue to improve their capabilities and meet our expectations. The CBES results show that while progress has been made, there is still much to do. From the point of view of capital, this suggests a third key judgement: are we satisfied that firms are building the capabilities they need – and if not, do we need to introduce more incentives?