Existing capability and regime gaps “create uncertainty” over whether financial institutions are adequately capitalised for future climate-related losses, says the Bank of England.
A new report by the Bank of England (BoE), acknowledged that banks’ and insurers’ risk capture may be “incomplete” due to difficulties in assessing climate-related risks (capability gaps) and challenges in capturing risks in existing capital regimes (regime gaps).
During a panel discussion at City and Financial’s Financial Services Climate Adaptation Summit, Chris Faint, Head of Climate Hub Division at the BoE, underlined the need for a better understanding of climate-related risks in the finance sector and across the wider economy.
“We want financial institutions to understand climate-related risks, to have the right discussions with their clients, and to be able to mitigate those risks and adapt to those risks over time to ensure that there is a smooth transition to net zero,” he said.
The BoE report, published this week, updated work from its Climate Change Adaption Report (CCAR) released in October 2021, which laid out its early thinking on climate change and regulatory capital frameworks for banks and insurers.
The new report noted that existing capability and regime gaps “create uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses”.
“This uncertainty represents a risk appetite challenge for micro and macroprudential regulators,” it said. “Regulators, including the Bank, need to form judgements on whether quantified and unquantified risks are within risk appetite – and act accordingly.”
However, the BoE added that there is not “sufficient justification” for regulators to make policy changes in the short term and it will continue to explore how climate-related risks can be adjusted within the timelines embedded in existing capital frameworks.
“The reason we care about a smooth transition to net zero isn’t because we have it in our remit to care about climate change per se, as a financial regulator, but because there’s a huge amount of evidence that a disorderly transition gives rise to more risks. Therefore, it is in all our interests to understand these risks and try to mitigate them as quickly as possible,” said Faint.
In its report, the BoE outlined that as a short-term priority it is focused on ensuring financial institutions make progress to address “capability gaps” to improve their identification, measurements and management of climate-related risks.
It also noted that to address “regime gaps” in the capital framework requires a more “forward-looking approach”, with scenario analysis and stress testing playing a key role. The BoE and other regulators, therefore, will need to focus on the development of these frameworks and how they inform capital requirements, with financial institutions expected to make further progress in this regard.
“Moving in the right direction”
Also speaking at the event, Sacha Sadan, Director of ESG at the UK Financial Conduct Authority, noted that climate is a systematic risk and, therefore, there is no “single answer” to address it.
“Everyone, including financial institutions, has a part to play.”
In 2023, the UK Transition Plan Taskforce, a government-mandated body which includes the FCA on its board / steering group, aims to finalise its disclosure framework and implementation guidance and will develop sectoral guidance. It also plans to increase its engagement with other jurisdictions and standard setters, including the International Sustainability Standards Board (ISSB) to support global convergence on transition plans.
Sadan stressed the importance of organisations understanding and using the TPT disclosure framework and reiterated that companies must start work on creating transition plans to nurture trust from investors.
“It’s okay to have a plan that doesn’t have all the answers,” he told onlookers. “It doesn’t need to be perfect, but if its reasonably good, investors can see you’re moving in the right direction.”
Faint stressed that the transition “has to start now” because losses are “significantly lower” in a smooth transition. But he noted that action shouldn’t move “too quickly” to avoid creating a “cliff edge” which may arise if certain sectors are cut off before alternatives to replace them are established.
He also noted that the financial sector can only move so fast in driving a smooth transaction, as the “real economy” requires investment.
“While the financial institutions have a lot of heavy lifting to do, we can’t transition the financial system without the real economy,” he said.
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