2021 CBES: Financial risks from climate change
On 24 May 2022, the PRA published the results of the Climate Biennial Exploratory Scenario (CBES), which explores the financial risks associated with climate change for the largest banks and insurers operating in the UK.
The CBES exercise is one of the Bank of England’s workstreams aiming to ensure that the financial system is resilient to climate-related financial risks. Those firms taking part in the exercise were required to quantify the impact of climate risks on their balance sheets and business models and assess the risk management actions which will be required to control these risks.
The results were based on three scenarios: risks from the transition to net zero by Early Action scenario (EA) and Late Action scenario (LA); and physical risks from climate change by No Additional Action scenario (NAA).
- EA: Climate policy is implemented in a well-managed and orderly manner from the beginning;
- LA: Policy measures are postponed by a decade, and are executed in a sudden and disorderly approach, leading to material economic and market disorder;
- NAA: Governments around the world fail to endorse policy responses to global warming.
The participating firms demonstrated how their businesses could be impacted in each scenario over 30 years.
Three main objectives of this exercise were to:
- present a consistent set of scenarios which UK firms could use to assess the impact of climate risk;
- assist firms’ and boards with the enhancement of climate risk management;
- size the risks that participants in the exercise face; and
- better understand how climate-related risks and their broader implications are likely to impact firms’ business models.
The most valuable findings of the CBES were:
- Overall costs will be lowest with early, well-managed action to reduce greenhouse gas emissions. So early action is important to lower the cost of the transition;
- The NAA scenario brings the worst outcome from the above scenarios;
- For life insurers, this was because forward-looking asset price impacts are greatest at the end of that scenario. Insurers’ asset values are projected to fall by 15% in the NAA scenario;
- For general insurers, this was via a build-up in physical risks, which resulted in higher claims for perils such as flood and wind related damage. UK general insurers projected a rise in average annualised losses of around 50% by the end of this NAA scenario.
- Overall, UK banks and insurers are expected to be able to absorb the costs of transition, but some of those costs that initially fall on banks and insurers will in the end be passed on to their customers and policyholders;
- General insurers would pass on the cost of higher claims into premiums eventually, or otherwise refuse renewal for riskier customers;
- Banks and insurers have a mutual interest in managing climate related financial risks in a manner that supports the Government’s climate policy. To do that, they still need to improve their climate change risk management;
- Projections of climate losses are uncertain, with wide error bands around all estimations. Scenario analysis in this area is still in its infancy and the scenarios used are not forecasts, but illustrations of possible paths;
- The projections demonstrate that if insurers do not react appropriately, climate risks are expected to cause a persistent and significant decrease in their profits. Overall losses are equivalent to an average drop on annual profits of around 10-15%. In the NAA scenario, CBES reveals an annual reduction on insurance profits of around £1.2bn for the life and general insurers taking part in the exercise.
Further work is required to greater understand the challenges:
- the need for more data on, and understanding of, customers’ current emissions and transition plans;
- the need to invest in modelling capabilities;
- 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;
- the need for banks and insurers to understand the carbon impacts of the real economy firms they finance;
- climate change risk could indicate higher future capital requirements to cover unexpected shocks during the transition;
- the need to introduce appropriate incentives for companies to continue to improve their capabilities and meet the PRA’s expectations.
Insurers have made progress in incorporating climate risk into their existing risk governance frameworks. Some firms are treating climate risk as a risk within and across its principal risks, and others as a separate principal risk. Many insurers have set target dates for their investment portfolios to be net-zero, and some have started tracking their current portfolios against these targets using available in-house Environmental, Social and Corporate Governance (ESG) data. Around half of the participating insurers have integrated climate scenarios into the stress and scenario tests included in their Own Risk and Solvency Assessment (ORSA) reports.
Insurers also noted numerous data challenges that they faced in estimating potential losses on their invested assets. These include incomplete data on companies’ emissions and their geographical locations and those of their supply chains.
The ability to assess and model physical risks in the CBES varied across firms, largely reflecting their varying capability to modify existing models. For example, insurers were able to model UK inland and coastal flood at a high level of geographical granularity.
Boards and senior executives must see climate risk as a strategic priority. It means ensuring firms hold sufficient financial resources to absorb losses arising from climate change. The CBES results are a snapshot, based on current data and modelling capabilities and focused on a specific set of scenarios and risks. The PRA has stated that this exercise is not going to be used to set capital requirements for banks and insurers.
The PRA has previously emphasised that smaller insurers, who were not part of the exercise, should take a proportionate approach that reflects their exposure to climate-related financial risk and the complexity of their operations. Some smaller firms may have more complex or concentrated exposures to climate-related risks, therefore the appropriate approach taken must be driven by the business model. Smaller insurers can address the financial risks from climate change through the firm’s existing risk management frameworks, in line with their board-approved risk appetite in a proportionate manner.