Climate change poses significant risks to the economy and to the financial system. While these risks may only crystallise in full over longer time horizons – and so may feel abstract and far away now – they are in fact very real, fast approaching, and in need of action today.
How does climate change affect the financial system ?
Climate change creates financial risks in two ways:
- Physical risks arise from damage to property, land and infrastructure as a result of catastrophic weather-related events and broader climate trends such as heatwaves, hurricanes, droughts, floods and rising sea levels. These are not just risks for 2040 and beyond. Inflation-adjusted insurance losses from such events have increased fivefold in recent decades;
- Transition risks result from changes in climate policy, technology and market sentiment as we adjust to a lower carbon economy. The need to transition is widespread, affecting not only energy companies but also transportation, infrastructure, agriculture and real estate to name just a few. It means that banks that have provided loans to those companies and investors that own their securities may find themselves with unexpected losses. The timing and the form of this transition is inherently uncertain. But risks are already materialising now - for example, through tightening energy efficiency standards affecting the UK property market or credit risks associated with the low-carbon transition emerging in the automotive and energy sectors.
The distinctive nature of the risk
The Bank of England has therefore been working to deepen its understanding of the risks that climate change poses to the financial system. It is clear to us that climate change creates financial risks that are core to our mandates of ensuring financial stability and the safety and soundness of the firms we regulate. But we have also been clear that the financial risks that climate change creates are distinctive and require a different approach if they are to be managed effectively.
First, the risks are far-reaching in breadth and in magnitude. They affect all sectors, all consumers and all geographies. Their impact will likely be correlated and non-linear. They will therefore occur on a much greater scale than other risks.
Second, the risks are eminently foreseeable. Although we not do know now the exact outcome, there is a high degree of certainty that financial risks from some combination of physical and transition factors will occur in the future. Uncertainty about what will happen cannot lead to inaction.
Finally, and most importantly, the magnitude of future financial risks will be determined by decisions taken today. The carbon we release today is creating the physical and transition risks of tomorrow. Climate change represents the tragedy of the horizon: by the time it is clear that changes to the climate are creating risks that we want to reduce, it may already be too late to act.
The Bank of England’s response
Central banks and supervisors therefore have a key role to play in enhancing the resilience of firms and the financial system to these risks.
In support of this aim, the Bank of England is considering the implications of climate change for its own operations, taking account of the financial risks from climate change whilst ensuring the purpose of our core operations as a central bank is preserved.
We have also published reports on the impact of climate change on the UK insurance and banking sectors. And we are working with the financial system to ensure these risks are addressed.
The actions of individual institutions will be critical in determining whether climate-related risks are well managed. To that end, and following several months of consultation, we recently became the first regulator in the world to publish supervisory expectations that set out how the banks and insurance companies we regulate need to develop an enhanced approach to managing the financial risks from climate change. The desired outcome is that firms take into account both current risks and those that can plausibly arise in the future, and identify the actions required today to mitigate both current and future financial risks. Our expectations cover governance, risk management, scenario analysis, and disclosure. They are designed to ensure firms take a strategic approach, led by the board, and with clear accountability. The approach needs to be holistic, forward-looking, embedded in business-as-usual risk management but grounded in the long-term financial interests of the firm, recognising that decisions taken today will create those far-reaching, foreseeable financial risks of the future.
We have deliberately not been prescriptive in our expectations, recognising that our understanding of this risk is immature but that it needs action now. Over the next year, as tools and expertise develop, we will embed more granular requirements into our policy, and so bring industry in line with our evolving expectations.
The UK Climate Financial Risk Forum
To support this development of best practice, we have established a UK Climate Financial Risk Forum, co-chaired by the Prudential Regulation Authority and the Financial Conduct Authority. The Forum brings together a wide range of industry participants as well as regulators and will help build intellectual capacity in this emerging field. We have established four workstreams – disclosure, risk management, scenario analysis and innovation – each of which will help us enhance our ability to identify and manage these risks.
Sizing the financial risks from climate change – The role of scenario analysis
Measuring the future risks from climate change to the economy and to the financial system is a complex task. A myriad of possible climate pathways – with different physical and transition effects – needs to be translated into economic outcomes and financial risks looking ahead over many decades. To simplify that challenge we need to focus not on what will happen but what might happen. And to do that we can use scenario analysis.
Using scenario analysis to paint a picture of the risks of continuing along the current climate trajectory creates a clear strategic imperative to act. Conversely, considering a scenario where our climate goals are met highlights the changes that will be needed to support a transition to a low carbon economy. Both therefore expose the customers, sectors and geographies that are vulnerable to physical and transition risks and so highlight the areas where action is required. Analysis of a disorderly transition – with sudden, unanticipated and discontinuous effects, perhaps prompted by the greater occurrence of extreme weather events – will demonstrate greater risk. That should incentivise financial firms to seek to pull forward the transition so that they are ahead of and in control of it - directing their capital to those that are resilient and avoiding those that are not.
By taking different decisions today, participants in the financial system are able to minimise their future financial risks. However, while necessary, that may not be sufficient to deliver a financial system that is resilient to the financial risks from climate change.
In particular, since there is one global carbon budget, we need to be able to assess whether the actions of institutions in aggregate deliver the orderly climate pathway that is required and which their individual plans assume. In this way, central banks can begin to stress the resiliency of the financial system to the risks from climate change.
The Bank of England’s policy committees will therefore consider including climate-related factors in a future Biennial Exploratory Scenario. The PRA will also ask UK insurers, as part of its market-wide insurance stress tests this year, to consider how their businesses would be affected in different physical and transition risk scenarios. And work is in hand internationally (through the NGFS - see below) to set out voluntary guidelines for how central banks and supervisors can use scenario analysis to assess system-wide financial risks from climate change.
Disclosure by firms is critical if the financial system is to be able to weigh risks and direct investment accordingly. The Bank has therefore supported the recommendations of the FSB Task Force on Climate-related Financial Disclosures (TCFD), which are instrumental in increasing transparency in the financial markets around climate-related risks. It is essential that disclosure is forward-looking, speaking to future risks and opportunities and not just current emissions. And we need to get to a position where we have a better basis for consistent comparisons across different firms.
The Network for Greening the Financial System
Climate change is a global problem that requires global solutions. Together with the Banque de France and others, therefore, the Bank has been a co-founder and keen supporter of the central banks and supervisors Network for Greening the Financial System (NGFS), whose aim is to share best practice and contribute to the development of climate-related risk management in the financial sector. NGFS membership currently consists of 34 central banks and supervisory authorities from across the globe. In April, the NGFS published its first comprehensive report, which sets out six recommendations for central banks, supervisors, policymakers and financial institutions to enhance their role in supporting the transition to a low carbon economy.
We need early action
It is not for central banks as financial policymakers to drive the transition to a low-carbon economy.
We do however expect the financial firms we supervise to manage these far-reaching, foreseeable future financial risks today. And if we work together, internationally and domestically, private sector and public sector, it is within our grasp to achieve a smooth and orderly transition.
But the window for minimising these risks and ensuring that orderly transition is finite and closing. We need early action, a sustained effort and a recognition that it is better to be roughly right now not precisely right when it is too late. Our work to seize that opportunity could not be more important. We must all play our part.
