This blog was published on 29 October 2021.
Who this blog is for:
Board members and senior executives working across the UK insurance and banking industries, in particular SMFs responsible for identifying and managing climate-related risks, CROs, Heads of Capital Management/Planning, and Heads of Climate Risk/Sustainability. It will also be of interest more broadly to Risk, Compliance and Sustainable Finance teams.
At a glance:
- In 2022, the PRA will intensify its supervisory work to assess firms’ progress against its supervisory expectations related to climate change, undertake a series of firm-specific activities and conduct further analysis of the regulatory capital frameworks in the context of climate change.
- From next year, UK banks and insurers will need to demonstrate further progress in their ability to understand and manage climate-related risks. In particular, the largest supervised firms will be asked to prepare a short report on how they have embedded climate-related financial risks into their risk management frameworks.
- Most banks and insurers in the UK will need to take action now to meet the PRA’s updated (and evolving) expectations, including for example carrying out work to satisfy themselves about the progress they have made to date and the robustness of their future plans. The increased attention that the PRA plans to pay to firms’ Net Zero transition plans is one indicator of the higher bar firms will need to meet in 2022 and future years.
- As the PRA progresses its work on climate-related risk capital considerations in the next year, firms will be expected to continue to ensure their capital adequately covers climate risks. In this context, as a starting point firms should review their ICAAPs and ORSAs to ensure they adequately address climate-related risks.
- The PRA will undertake a number of firm-specific activities and conduct further analysis in relation to the regulatory capital framework in the context of climate change, before setting out its proposed approach in Q4 2022.
Reading time: 7 minutes
On October 28, just days ahead of COP26, the PRA published its Climate Change Adaptation Report. The PRA used the report to herald a more intensive approach from 2022 to the supervision of firms’ climate-related financial risk management. The report also provides details of how the PRA plans to assess whether the current prudential framework adequately captures climate risk. Most banks and insurers in the UK will now need to take action to meet the PRA’s updated expectations.
This step change in supervision follows the deadline set out in the PRA’s Dear CEO letter from 2020, requiring UK banks and insurers to embed their approaches to managing climate-related risks by end-2021, and demonstrate that they have implemented and internalised the expectations set out in SS3/19. From 2022, the PRA will fully incorporate climate change into its supervisory approach.
This means that from next year, UK insurers and banks will need to demonstrate, on an ongoing basis, their ability to understand and manage climate-related risks, making further improvements with time. And the PRA warns that where firms do not keep pace with supervisory expectations – and assurance or remediation is therefore needed – it will “stand ready to respond with [its] supervisory and regulatory toolkit”. For each of the largest supervised firms, the SMF responsible for climate change will have to present an assessment of how the firm has embedded climate-related risks into its risk management framework to the PRA. Furthermore, the PRA will look at firms’ net zero transition plans, and will consider climate-related disclosures and reporting further.
The PRA will also do more analysis in the coming year in order to determine what changes need to be made in order to capture climate-related risks fully in the capital framework. In the meantime, the PRA will expect firms to make as effective use as possible of the existing prudential framework, including by adopting best practices for the assessment of climate-related risks and by enhancing their ICAAP or ORSA.
This blog explores the PRA’s step change in its supervisory approach in more detail.
Still more to do on managing climate-related financial risks
The PRA notes that since the publication of SS3/19, firms have made significant progress in embedding its supervisory expectations, but there are inconsistencies across firms and some firms have shown more ambition than others. For example, “while challenges arising from issues such as data gaps persist, the PRA expects firms to use their judgement, expertise, and tools available to them, to demonstrate their understanding and management of risks posed by climate change to their business”. The PRA also notes that this approach will then “need to evolve as the industry-wide understanding of climate-related risks, data tools and best practice continue to develop”. Firms will have to invest further to meet expectations and continue to take a strategic and ambitious approach to embedding climate-related financial risk management across their organisations.
A shift in supervisory approach
In 2022, the PRA will actively start to supervise firms against the expectations set out in SS3/19, warning that the end-2021 deadline is a “checkpoint, not a full stop”. As the management of climate-related risks will become subject to formal supervisory assessments, Boards, firm executives and senior managers will be expected to demonstrate their understanding of the risks that climate change poses to their areas of responsibility, and their plans to address them.
As part of its evolving supervisory strategy, the PRA will undertake a number of firm-specific activities in the year ahead to assess progress against its expectations. This includes assessing firms’ individual strategies to meet SS3/19, as well as reviewing firms’ disclosures. Importantly, the largest supervised firms will be asked to prepare a short report on how they have embedded the management of climate-related financial risks into their existing risk management framework alongside their 2021/2022 ICAAP or ORSA. The SMF responsible for identifying and managing climate-related risks will have to present this assessment to the PRA. The PRA also intends to ask a sample of the remaining firms to prepare a report.
All banks and insurers should review their future plans thoroughly, to satisfy themselves on the progress they have made to date and the robustness of these plans. They should identify any gaps in terms of progress against supervisory expectations, and come up with an action plan to address these.
By the end of 2022, the PRA intends to provide an update on a number of other climate-related financial risk areas, including in relation to regulatory returns and firms’ transition plans. For the former, the PRA will consider what regular data supervisors could require from firms and if there is a need to obtain this information via regulatory returns. Firms should therefore make Pillar 3 and strategic report disclosures from the end of this year, but also monitor and engage with PRA consultations on climate-related reporting requirements in the year ahead.
In relation to firms’ Net Zero transition plans, the PRA explains that it will use these to assess progress on transition at a firm and system level. Increasing scrutiny on firms’ transition plans will be a growing trend in 2022, both in the UK and EU. In a speech last week, Frank Elderson of the ECB suggested banks could face a ‘legal obligation to have clear, detailed and prudent transition plans in place’, and proposed powers in the Capital Requirements Directive (CRD) for supervisors to be able to force firms to change their business model if they are misaligned with broader ESG trends and EU objectives.
The paper also provides the most comprehensive overview to date of the PRA’s thinking on the integration of climate risks into the capital regime. The PRA concludes that there is already scope to use capital requirements to address certain aspects of climate-related financial risks under the existing regulatory capital framework for banks and insurers. This is the first time that the PRA has placed such emphasis on the need for firms to satisfy themselves that they hold enough capital to cover their risks – a shift from their previously cautious stance.
Much like the ECB’s position, the PRA’s report indicates the Pillar 2 framework is a promising avenue for climate-related capital requirements in the short-term, with relatively fewer capability and regime gaps to address. Banks are, for example, already required to cover climate-related risks in their ICAAP and insurers in their ORSAs. The PRA indicates the prospect of capital add-ons for firms with particular weaknesses in their climate risk management capabilities. This aligns with recent statements by the ECB and the BCBS. At the moment, the key action for firms is therefore to review their ICAAPs and ORSAs to ensure they are addressing climate risk appropriately ahead of any potential future changes to the prudential framework.
The PRA also evaluates the possibility of addressing climate risk through the macroprudential regime, reflecting a growing interest among policymakers in using macroprudential tools to address climate-related risk in the medium-term. In addition to the continued use of stress tests such as the CBES, the PRA will explore other macroprudential tools, including system-wide capital buffers or Sectoral Capital Requirements for both banks and insurers. This signals that the tools to tackle climate-related risks could eventually permeate through all parts of the regulatory capital stack.
However, the PRA recognises that there are significant obstacles to integrating climate risk into certain parts of the framework. For banks, for example, the overarching design of the existing Pillar 1 capital framework would need to be amended to capture climate-related risks. For instance, the standardised and IRB approaches for credit risk are based on historical losses and forecast over a 1-year time horizon – both of which are not suitable for climate risks; a challenge that was also mentioned by the ECB recently. In the meantime, the PRA intends to support integration of climate risks in the Pillar 1 framework by providing further detailed guidance to help firms scale-up their capabilities.
Lastly, the PRA questions the effectiveness of using the capital framework to incentivise firms’ behaviours through ‘green supporting’ or ‘brown penalising’ factors, as doing so may lead to unintended consequences. This view is shared internationally. Indeed, the European Commission’s legislative proposal for CRD6/CRR3 does not include an explicit climate scaling factor, reflecting the prevailing view that, as yet, there is insufficient evidence to support its inclusion in the capital framework. On the insurance side, the story is similar. The European Commission in its recent Solvency II proposal did not include climate-related capital considerations, but rather mandated EIOPA to explore by 2023 a dedicated prudential treatment of climate-related exposures. The EBA is due to produce the equivalent analysis for the bank capital framework to the same timetable.
From the beginning of 2022, the PRA will undertake firm-specific work to determine their progress to meet its expectations set out in SS3/19. This includes assessing firms’ plans for meeting these expectations and getting assurance over firms’ approach to climate-related capital adequacy assessments. By June 2022, the PRA will assess firms’ approaches to climate in ICAAPs and ORSAs, and Pillar 3 disclosures. Throughout this process, firms should engage with and discuss these matters proactively with their supervisors.
In the next year, the PRA will undertake further analysis to explore enhancements to the regulatory capital frameworks in the context of climate change over the next year, with a final report on its views on incorporating climate into regulatory capital, building on existing requirements, due in Q4 2022. The EBA and EIOPA reports are due shortly after this, in 2023, though in practice, we expect implementation to be quicker in the UK given EU legislative processes. Firms should engage with both the PRA and European supervisors where relevant, including participating in the PRA’s Research Conference or responding to any information requests to support further regulatory analysis.
In the meantime, the PRA will continue to use the existing prudential framework to mitigate climate-related financial risks as per its existing supervisory expectations. For example, firms will continue to be responsible to ensure their capital adequately covers climate risks, and the PRA can continue to consider tools that affect capital, including firm-specific capital scalars or add-ons.
All firms, even those that are relatively well progressed in terms of how they address climate-related risks, will now need to accelerate the speed at which they embed this in their risk management practices and strengthen the alignment with their strategic plans for the climate transition.