UK banks face 'fiendishly complicated' Bank of England climate stress test

·Senior City Correspondent, Yahoo Finance UK
·4-min read
EMBARGOED TO 0001 MONDAY JANUARY 25 File photo dated 20/09/19 of the Bank of England, in the City of London, which risks creating a
The Bank of England. Photo: PA

The Bank of England has published new details of its upcoming climate stress tests for banks and insurers.

The central bank on Tuesday published details of its 2021 Biennial Exploratory Scenario, which will analyse climate risk in the financial sector. The Bank of England regularly runs stress tests to look at emerging and novel threats to the financial system but this year will mark the first time climate risks have been assessed. 

19 of the UK's biggest banks and insurers will face detailed analysis of risks to their business from rising temperatures around the world and so-called "transition risk" — how the shift to net zero carbon emissions could affect them. Banks will be asked to measure potential loan losses against three scenarios, while insurers must asses how the value of their assets and the cost of their liabilities could shift due to rising temperatures and changing policies.

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As well as obviously impacted industries like oil and gas, banks and insurers will be asked to look at transition plans and climate impact in sectors ranging from real estate to agriculture. The Bank of England said the exercise would help shine a line on "opaque" balance sheet risks and help businesses plan for the future.

"Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole," Bank of England governor Andrew Bailey said in a statement.

"It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks.

"The end result will be more robust management of climate related financial risks across the sector."

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Finance firms' balance sheets will be analysed over a 30-year time horizon — much longer than the three to five-year range usually used in stress tests. 

Balance sheets will be judged against three scenarios: one where governments and corporate management teams around the world take early action to head off climate change; one where they take late action; and one where no action is taken. 

In the best case climate scenario, global warming is limited to 1.8°C by 2050 and the biggest risk to financial firms is policy action that makes certain model models unviable and requires new business models to be developed. 

In the worst case scenario, average temperatures climb by 3.3°C over the next 30 years and the biggest risks become climate factors — floods, droughts, wildfires, and cyclones, which could impact loans, assets, and liabilities. 

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"Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system," Sarah Breeden, the Bank of England's climate sponsor, said in a statement. 

"Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action."

The analysis is a "learning exercise", the Bank said, but could inform policymaking in the future. Banks and insurers found to hold the greatest climate risks could be asked to set aside more capital to cover potential losses in future, for example. The Bank of England hopes to nudge business leaders to take pre-emptive action rather than be forced to set aside capital. 

"By highlighting the risks of tomorrow, they can help guide actions today," Breeden said. "I encourage all firms, not just those participating, to engage in and learn from this exercise."

David Barmes, a senior economist at campaign group Positive Money, said the exercise was "useful" but said it was "concerning" that the Bank of England had ruled out action on capital.

"Climate capital rules that reflect the high risk of fossil fuel investments are a necessary inevitability to ensure financial stability and alignment with the government’s climate plans, and the Bank needs to be introducing such policies without delay," Barnes said.

Results of the stress test are set to be published in May 2022. Firm-level results will not be published, with only sector-wide assessments made public.

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