The Bank of England's Climate Biennial Exploratory Scenario | ‘Climate KYC’ and other initial reflections for banks

This blog was published on 25 May 2022.

The Bank of England (BoE) published the results of its Climate Biennial Exploratory Scenario (CBES) on 24 May, with the PRA’s CEO, Sam Woods, delivering an accompanying speech summarising the key messages. The CBES has been run by the largest UK banks and insurers over several months, and the results – which amount to nearly 80 pages – will take some time to digest fully.

Given this regulatory climate scenario analysis is amongst the first of its kind internationally, and given the participation of the largest UK banking and insurance groups, there is widespread interest in understanding the outcome. This note provides a perspective on the results; specifically, whether the UK banking system as a whole is sufficiently resilient, and what remains to be done.

The publication should be of interest to all banks, not just those that participated in the CBES. The BoE expects all banks to develop climate risk assessment capabilities, proportionate to the size and complexity of their business.

At a glance:

1. Projected climate-related losses do not appear to threaten the solvency of banks, but the size of losses may be underestimated.

2. Amongst the three climate scenarios, the scenario with an early, orderly transition stands out as the best of all adverse outcomes for the economy as a whole.

3. The second round of the exercise sheds light on both the costs of the transition and the urgency of supporting customers and clients on their climate transition journeys, demonstrating the merit of exploring feedback effects

4. Banks still have plenty of work to do, with securing a better understanding of customers’ and counterparties’ climate transition plans (‘climate KYC’) topping the list.

5. Banks that were not in scope also have plenty to learn from the exercise, in particular from the good practices identified by the BoE.

6. The publication of the CBES results did not shed any light on the BoE’s future approach to integrating climate risks into the bank Pillar 1 capital framework, but the results will feed into the BoE’s ongoing evaluation. 

7. More climate stress tests are likely, but may take different formats to the first CBES.

These themes are explored in more detail below.

1. Projected climate-related losses do not appear to threaten the solvency of banks, but the size of losses may be underestimated.

The CBES required participants to run three climate scenarios characterised as: an early, orderly transition scenario; a late, disorderly transition scenario; and a ‘no additional action’ scenario.

Although the CBES projected significant losses for participating banks over the course of the economy’s transition to net zero, in the PRA’s assessment, in none of the three scenarios is there a threat to solvency of the banks – i.e. there is no immediate need for additional capital, at least at the aggregate level. That said, given the uncertainties about the path of the economy’s transition, the challenges of translating climate-related stresses into macro-financial implications, and the limitations in the scope of the BoE’s analysis (with only credit risk in scope for banks), the actual costs of the transition remain somewhat uncertain.

So whilst the BoE takes comfort for now from the resilience of banks demonstrated by the CBES, this analysis will not be the final word on the matter and banks should expect further scrutiny of their climate risk exposures over the coming months and years.

Recommendation for banks: Invest in understanding how climate risk may affect risk types not covered by the CBES, such as market risk.

2. Amongst the three climate scenarios, the scenario with an early, orderly transition stands out as the 'least worst' scenario for the economy as a whole.

The results of the exercise support the intuition that most would have expected - that an early, orderly transition could be less costly (from a profitability perspective) to all banks than a late, disorderly transition. In the latter, the losses would be higher, and significantly concentrated within a short period. Both the orderly and disorderly transition scenarios demonstrate that the short-term costs of transitioning to a low carbon economy are far outweighed by the cost of inaction on the policy and institutional front.

Recommendation for banks: Consider how your firm’s transition plan may need to adapt to different transition pathways, such as a disorderly transition

3. The second round of the exercise shed light on both the costs of the transition and the urgency of supporting customers and clients on their climate transition journeys.

The BoE ran two iterations of the CBES. In the second round, banks were asked to provide details on their planned responses to the scenarios. This revealed the risk that the coordinated execution of banks’ (and insurers’) transition plans could potentially exacerbate transition risks – for example, with changes in bank lending patterns reducing the ability of high emitting corporates to access the finance required to make the transition to net zero, or home insurance becoming inaccessible to homeowners in areas that are particularly prone to flood risk.  The BoE emphasises that “it is in the collective interest of banks and insurers” to support the adaptation of highly exposed counterparties with credible transition plans, and to “gradually reduce” their exposures. In summary, the financial sector’s transition to net zero needs to be managed carefully, and financial services firms need to avoid “running ahead of the economy” – for example by reducing the access to finance of high-emitting sectors before low-emitting alternatives are mature enough to fill the gap. This was a significant and important finding and underscores the merit of exploring feedback effects. 

A similar message was given recently by Sarah Breeden, Executive Director for Climate Risk at the BoE, in her speech on ‘Balancing the net-zero tightrope’. This is clearly a current area of focus for the BoE, and very likely to be raised in supervisory conversations with banks.

Recommendation for banks: Consider whether your climate risk appetite is appropriately calibrated to help highly exposed counterparties to transition 

4. Banks still have plenty of work to do, with securing a better understanding of customers’ and counterparties’ climate transition plans topping the list.

Although banks’ climate risk management capabilities have clearly progressed, and business models are not directly in threat, more remains to be done. In particular, the modelling and data capabilities from which the conclusions have been drawn are far from complete and precise. The BoE considers that filling those capability gaps is an important pre-requisite to banks incorporating climate risks into their business decisions.

The near-term priority for banks should be filling in several gaps identified by the PRA. It is clear that banks need to do a fair bit of ‘climate KYC’. This might include: 

• Populating data gaps that were revealed by the CBES exercise – such as missing postcodes for corporates’ physical assets, and up-to-date EPC ratings for properties
• Gaining a better understanding of counterparties’ current emissions (across their entire value chains)
• Evaluating the quality and feasibility of their clients’ transition plans

Ongoing initiatives (such as the development of common reporting standards by the International Sustainability Standards Board (ISSB), and the development of a ‘gold standard’ in transition plans through the UK government’s Transition Plan Taskforce) should help standardise the data that banks collect from their counterparties.

However, the BoE expects banks to do a lot more heavy lifting through direct engagement with their counterparties. Such engagement would help banks to address some of the more specific data challenges listed above, and more broadly to understand whether their counterparties are truly well-placed to make the transition to net zero, to understand the most relevant risks at a counterparty rather than sectoral level of detail, and even to identify opportunities for transition financing.

Modelling climate risks is also identified as an area of improvement. Many of the banks that participated in the CBES do not appear to have invested in developing in-house modelling capabilities, relying instead on third party vendors. Although the BoE stops short of requiring banks to develop in-house capabilities, it cautions that banks that use third party vendors should look to improve their ability to scrutinise, challenge and customise the models that are ultimately used. Climate models ultimately need to be given the same rigour as all other models that banks use.

Recommendation for banks: Focus your near-term efforts on engaging with counterparties to fill in relevant data gaps and understand better their transition plan

5. Banks that were not in scope also have plenty to learn from the exercise.

Smaller banks, not currently in scope of the CBES, can expect to face many of the same capability gaps as their larger peers. The BoE’s publication includes a number of good practices observed over the course of the exercise. Those good practices, although not necessarily the endpoint for climate risk management, can help smaller banks benchmark their own practices against current market leaders. Banks not in scope and less familiar with climate stress testing may want to engage with the industry through fora such as the BoE and FCA-supported Climate Financial Risk Forum.

The PRA’s supervisory strategy, and its understanding of banks’ progress against supervisory expectations, will be informed by the findings of the exercise.  Banks that have yet to undertake climate stress testing, particularly those with more material climate risk exposures, can therefore expect similar scrutiny of their data and modelling capabilities as part of their ongoing dialogue with supervisors.

With climate risk now part of the PRA’s day-to-day supervision for all banks, and banks that did not participate in the CBES should not assume they can wait for further instructions before starting to take action

Recommendation for banks: Evaluate your own capabilities against the good practices identified by the BoE

6. No further clarity on the BoE’s future approach to integrating climate risks into the bank Pillar 1 capital framework, but the results will feed into the BoE’s ongoing evaluation. 

As stressed by the BoE on numerous occasions, the CBES was never intended to have a formal link to bank capital requirements. And given the BoE’s assessment that the transition does not create clear risks to banks’ solvency, there appears to be no imminent prospect of a decisive near-term micro- or macroprudential response. That said, the results of the CBES will undoubtedly influence the BoE’s thinking as it explores how the prudential capital framework should best accommodate climate risk. The systemic risks identified by banks’ management actions, for example, could influence the BoE’s thinking on potential reforms to the macroprudential framework, and the results of the CBES will allow the BoE’s Financial Policy Committee to monitor whether system-wide capital levels continue to be sufficient to cover climate-related systemic risks. Sam Woods also emphasised that, in line with the approach set out by the PRA in its climate adaptation report and by the EBA in its recent discussion paper on the role of environmental risks in the prudential framework, any amendments to the Pillar 1 approach would need to be very risk-granular (rather than seeking to incentivise any particular climate outcome).

Recommendation for banks: Engage with the PRA (and the EBA, where appropriate) to set out your views on the feasibility and impact of different options being considered, and try to quantify the impact of the policy options that you feel would be most material to your bank

7. More climate stress tests are likely, but may take different formats to the first CBES.

Although scenario analysis will continue to be at the forefront of both banks’ and supervisors’ efforts to understand and manage their climate risk exposure, the BoE has not yet decided whether it will run a ‘CBES 2.0’ in the future. As Sam Woods indicated in comments following his speech, repeating the same exercise could yield diminishing returns in terms if insights into banks’ capabilities. And in any case, it will take some time for banks to make the data and methodological improvements required to produce more robust results. Future exercises that are run could look at different scenarios (such as the impact of a near-term policy shock), different risk types (such as market risk), or use a dynamic balance sheet assumption instead of the fixed balance sheet assumption used in this exercise.

As part of its broader review of the capital framework, the PRA is also considering whether future exercises could be formally linked to capital requirements. This raises the prospect of the Annual Cyclical Scenario stress test being explored as a tool for examining firm-specific capital requirements in relation to banks’ climate risk exposures, although it was recognised that the shorter time frames (typically 5 years or less) may limit both the type of scenarios and risk types considered.

Recommendation for banks: Continue to invest in your scenario analysis capabilities so that you are well placed for future exercises