Why Physical Climate Risk?

Since the Bank of England published its initial SS 3/19 supervisory statement, outlining their expectations for firms to embed climate-related financial risks into their risk management frameworks, the regulator has always placed equal emphasis on both transition and physical risk. However, there has been less observed focus on physical risk across the financial market[1], mostly due to the uncertainty of the impacts of climate change on physical risks, such as hurricanes and flood. Where assessments of physical risk are conducted, there are recognised limitations in approaches such as a tendency to use historical data[2] instead of forward-looking data. If not properly addressed these limitations could result in systematic underestimation of physical climate risk and potentially cause knock on effects for broader climate risk management and long-term strategic planning. 

Looking ahead, UK Banks are likely to face further scrutiny from the regulators on their assessment of physical risk and be expected to refine their approaches as scientific understanding of physical risk progresses and modelling capabilities develop. In this blog we aim to outline the current regulatory requirements in the UK for Banks assessment of physical climate risk and how these might change going forward.

 

Regulatory expectations for UK Banks

As detailed in the Bank of England’s SS 3/19 and Dear CEO letter (2020), UK Banks are expected to embed physical climate risk into their risk management frameworks, ensure governance is in place to oversee the risk and appropriately disclose material physical risks. As part of risk management Banks are expected to:

  • conduct materiality assessments to assess if physical risk has potential to impact the financial health of their asset portfolios/banking book 
  • where material, tailor their own approach to assessing physical risk which is proportionate to the size and complexity of their business model 
  • explore the potential financial impacts of physical risk in both the short and long term via stress testing 
  • discuss stressed results in their ICAAPs (Internal Capital Adequacy Assessment Process) with the aim to understand if:
    • adequate capital is set aside for material risks in the short term 
    • decisions need to be made as part of long-term strategic planning

The Bank of England’s Climate Biennial Exploratory Scenarios (CBES) Guidance released in June 2021 is also a useful benchmark for understanding what is expected by the PRA for stress testing of physical risks via scenario analysis. The guidance encourages participants (a selection of the UK’s largest Banks and Insurers) to consider UK flooding, both coastal and inland, as the key physical risk on their mortgage portfolios because historical events have highlighted UK properties are particularly exposed to flood risk. There are also strong indications from climate change projections of rainfall averages and sea level rise that flood events in the UK are expected to become more severe[3]. 


Changing regulatory expectations 

However, looking ahead the PRA’s Climate Adaptation Report (October 2021) hints that current expectations around management of physical climate risk could change. In the report the PRA comments on observed progress so far across the financial sectors, highlighting gaps such as a lack of quantification of physical climate risk due to data and modelling challenges. The report also outlines the PRA’s climate change strategy for 2022, moving its approach to actively supervising firms to meet the expectations set out in SS 3/19, especially since the end of 2021 checkpoint to “fully embed their approaches to managing climate-related financial risks” has passed.

Changes in the UK climate regulatory landscape could mean UK Banks are likely to be scrutinised on the following:

  • Long term analysis’ – The PRA observed that long term scenario analysis’ undertaken to inform strategy are still relatively short (3-5 years) and recognised a reliance on historical data, both which have potential to underestimate long-term physical climate risk.
  • Enhancements plans – Whilst most assessments of physical risk are conducted on a high-level and qualitative basis, Banks may be requested to show clear enhancement plans which show how they will be refining their approach over time and moving to quantitative basis.
  • ICAAP reviews and capital – The PRA will be further reviewing Banks ICAAPs this year to assess if climate risks are covered by adequate capital.
  • CBES exercise – The CBES exercise could potentially expand to the wider financial market once the 2021 CBES results are released May 24th 2022.
  • Other perils – The focus has been on flood risk assessments in the UK however the PRA still expects Banks to assess other material perils.


Financing climate adaptation 

Another driver for shifting focus onto physical risk is climate adaptation, one of the key topics in the IPCC’s Impacts, Adaptation and Vulnerability Report. As the impacts of climate change on physical risks are expected to become more apparent in the coming years and as it becomes increasingly too late to limit some of these impacts via mitigation (e.g., reducing carbon emissions), there are mounting calls for investments in climate adaptation measures which adjust to the inevitable impacts of climate change. This means governments, regulators, and the financial sector will need to understand better where their material exposure to physical risks are for strategic investments in adaptation and resilience measures, such as protecting coastlines from expected sea-level rise.


Conclusion 

With the impacts of climate change on physical risks becoming better understood and modelling capabilities developing rapidly across the risk management market, the regulators and the financial sector will increasingly shift their focus onto physical risk. The CBES exercise results released at the end of this month will also be a useful guidance for UK Banks looking to develop and enhance their physical risk management capabilities.  Other factors such as financing climate adaptation initiatives, means it will be more imperative than ever for UK Banks to understand where their material exposure to physical risks are and ensure they have the best tools and expertise to assess its potential impact on their portfolios.

 

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References: 

[1] The World Bank - Assessing Financial Risks from Physical Climate Shocks: A Framework for Scenario Generation

[2] Climate-related financial risk management and the role of capital requirements (bankofengland.co.uk)

[3] UK and Global extreme events – Heavy rainfall and floods - Met Office