Earlier this month the PRA published its Dear CEO letter on managing climate-related financial risks. The letter reflects the PRA’s observations following its review of the climate risk management plans submitted by banks and insurers last year. Overall, while the PRA found that most firms are making good progress in developing their climate risk approaches, it identified a number of gaps that firms need to address.
The PRA’s letter follows the launch, by the Climate Financial Risk Forum, of its Climate Guide and is intended to be read alongside it, with the Guide drawing upon industry experience to elaborate on current good practice in climate risk management, disclosure and scenario analysis.
Below, we set out ten key take-home points from the Dear CEO letter that firms should keep in mind when implementing their climate risk management plans.
1. Firms should get moving with embedding their climate risk plans now
The PRA has now specified the end of 2021 as the deadline for firms to have implemented and embedded the PRA’s climate requirements set out in SS3/19, whilst also confirming its intention both to continue engagement with firms on this and integrate climate risk into its full range of supervisory activities. Come the end of 2021, given that firms will have had a total of two and a half years to embed their plans, along with a raft of regulatory and industry guidance to help them do this, we do not expect the PRA to be sympathetic to non-compliant firms.
This deadline is likely to prove a stretch for some firms as the PRA had not previously mentioned an implementation deadline, and many firms will have been occupied by their response to COVID-19. They may therefore have delayed their implementation timelines.
Indeed, our own experience is that a number of firms are only just starting to work out how to execute their plans, with firms initially reporting, as key challenges, the gathering of granular data on clients and the integration of climate risks into risk management frameworks (and specifically accessing climate risks of clients and their supply chains). The latter will, for example, require skills/data enhancements along with changes to templates, systems, analytics and methodologies.
As well as planning for this new deadline and ensuring that resourcing and capabilities are sufficient to achieve it, firms should also ensure that, in the interim, they provide their boards with periodic and sufficiently comprehensive updates regarding the embedding of their plans.
2. Firms should start building/enhancing scenario analysis capabilities now
The PRA highlights that it expects all firms to undertake scenario analysis which is proportionate to their size and complexity. It recognises that this is a challenging area which will take time for firms to implement. Firms should therefore ‘increase capabilities materially in the near-term’ and look to address shortcomings in their data and tools – this was a point made in the recent Dear CEO letter to insurers, following the insurance stress test in 2019. Firms should additionally look to include scenario analysis into their broader risk assessments.
The letter goes on to provide additional pointers for conducting scenario analysis through noting, for example, that:
- Firms may consider using standard reference scenarios as a starting point (e.g. scenarios provided by the NGFS and the PRA as part of the BES); these can then be tailored to the firm
- Scenario analysis should consider physical and transition risks and should cover both the short term (business planning horizon) and long term (the PRA specifies decades)
- The results of the scenario analysis should filter through into e.g. risk appetite, risk management framework, business strategy etc.
3. Firms should discuss scenario analysis results in ICAAPs and ORSAs as they develop capabilities
The PRA notes that more advanced firms are currently including within their ICAAP or ORSA: descriptions of the types of climate risk scenarios considered, how detailed these are, along with a description of any modelling approaches and model types used, including consideration of the assumptions and uncertainty in each of the key building blocks.
Firms may also wish to take account of other good practice observed by the PRA with regards to ICAAPs and ORSAs which include:
- Explaining how climate risk is embedded into risk frameworks
- Describing how assets are classified for climate risk
- Identifying what climate risk means for balance sheet valuations
- Confirming the proportion of the balance sheet evaluated and updating action plans regularly to quantify and mitigate climate risk.
4. Firms should focus on developing climate metrics and targets
The PRA stresses the importance of firms using climate metrics and targets both to identify and measure climate risks. Whilst it acknowledges that challenges exist in this area, it expects firms to ensure that identified risks are recognised through the use of reasonable proxies and assumptions. This is an area that the PRA will be paying particular attention to, whilst also looking closely at how metrics and targets are incorporated into risk and governance frameworks.
5. Firms should develop their risk management processes to better reflect climate risks
The PRA highlights that when it comes to managing climate risks, firms can better integrate climate risks in their risk management processes through implementing:
- Integrated policies
- Mitigation strategies
- Monitoring capabilities
- Well-defined risk appetites that consider current balance sheet and business model risk.
Some good practices firms may wish to keep in mind include: modelling of climate impacts on capital through e.g. climate‑adjusted probability of default and/or loss given default (banking) and the use of an internal climate impact risk weight.
In our view, firms should also look to incorporate climate-related risk management into new lending and underwriting in order to prevent the stock of business that will need to be remediated growing bigger. Through doing this, firms can also benefit from some “learning by doing”.
6. Firms should prioritise implementing processes for engaging with clients and counterparties to obtain climate data
A number of the climate risk management plans submitted to the PRA by firms failed to show that they had initiated a process for conversations with clients and counterparties to take place about physical and transition risk factors. Given the importance of these conversations in terms of securing climate data for risk identification and assessment purposes, this is something firms should look to address.
Some additional instances of good practices firms may wish to keep in mind include the gathering of climate data during on-boarding and annual reviews and the provision of staff training for staff conducting on-boarding /undertaking credit risk assessments.
7. Non-listed firms in particular need to start work on, and build capacity in the area of disclosure
The letter flags that the majority of firms outside the largest, largely listed, firms have not yet produced disclosures. These firms in particular should make a start given that this is a ‘multi-year endeavour’ and others which have, should continue to build capabilities.
The PRA is keen to highlight to firms that various initiatives are underway to integrate TCFD disclosure requirements into the regulatory framework. It flags its support for Government expectations for TCFD disclosure by large asset owners and listed companies (by 2022), refers to the FCA’s TCFD comply or explain proposals for premium listed issuers which capture ‘a significant proportion of larger PRA-regulated banks and insurers’ (and which could apply sooner), along with the UK cross-government/regulator taskforce. This is examining the appropriateness of making reporting mandatory.
The PRA suggests that those firms in the earlier stages of their disclosure journey should adopt a phased approach, starting with qualitative disclosure and later progressing to quantitative disclosures. In terms of good practice more generally, it flags comprehensive publication of TCFD format disclosures in annual reports. It also notes that smaller banks are intending to disclose their climate risks in their Pillar III disclosures, which it also considers acceptable.
8. Firms should be clearer about their strategic responses to climate change and ensure that climate management information is communicated consistently discussed at board level
Firms can improve shortcomings in their strategic responses to climate risk by, for example, categorising assets subject to climate risk and considering the corresponding strategic options. The PRA also notes in this respect that some firms have considered their role in supporting their clients and counterparties to meet net zero emissions by 2050. Firms should also look to develop tools to inform their business decisions e.g. early warning indicators or related metrics. It could be helpful for example to hold explicit conversations at board level on the projected impact of the profitability of the various strategic options for responding to climate risk.
On board level discussions, the PRA reiterates that boards are responsible for setting climate-related financial risk appetites and obtaining assurance for this and notes that more advanced firms provided training for the board to oversee such risks. The PRA additionally reminds firms that they should be taking climate risk into account when determining variable remuneration.
9. Firms need to be better at showing they understand climate risks and their relationship to financial risks
The PRA clarifies that firms should have a clearer understanding of the physical and transition risk transmission channels and interactions between multiple lines of business, sectors and geographies. Firms can for example look to achieve this through their climate risk governance structural arrangements through drawing clear distinctions between elements of climate risk as a financial risk, a reputational risk and a corporate responsibility issue and amending committee terms of reference to include explicit references to climate risk.
10. Proportionality does not mean that smaller firms have nothing to do
Smaller firms will need to implement the PRA’s expectations in a way that is proportionate to both their business model and size. The PRA emphasises that smaller firms are not immune from climate risks and could, in certain cases, actually be more susceptible to climate risks if they are concentrated in a vulnerable sector, product or geography.