Promoting a sustainable future – why the regulator is stepping up on climate change

Alan Sheppard, Head of Insurance Policy, Bank of England explains how the Prudential Regulatory Authority will encourage sustainable investment behaviour

Insurance Investor Editorposted on Wednesday, September 11, 2019

This article is taken from the research report Insurance Asset Management – Europe 2019, which can be downloaded in full here.

Not very long ago, few would have considered climate change as something that central banks or regulators should be thinking about.

Most senior officials in central banks would have felt they had their objectives for monetary and financial stability and that these could and should be pursued independently from tackling climate change.

This has changed. The realisation that there are huge financial risks arising from climate change and that risk mitigation is directly part of our objectives as financial stability authorities, has made the subject mainstream in a relatively short time.

Therefore, in the UK the PRA issued a consultation paper in October 2018 that sets out at a high level our understanding of the financial risks that arise for regulated entities – both banks and insurers – from climate change.

Some insurers that insure physical risks are already well aware of the risks on the liability side of their balance sheets from increased incidence of extreme weather and flooding, for example.

But understanding of risks to their assets on the part of both banks and insurers is less well developed.

Three key effects

The financial risks from climate change arise in two ways: from the physical impact of climate change itself or from the governmental and societal responses to change or the threat of change.

We call these the two sources of shock: physical which is the direct impact of changing climate on both assets and liabilities; and transition which is the impact, primarily on assets, of the measures that governments and societies take in order to reduce carbon output and limit climate change or mitigate its impacts.

Financial risks from climate change have several distinctive elements which, when considered together, present unique challenges and require a strategic approach.

These elements include:

  • Far-reaching in breadth and magnitude: the financial risks from physical and transition risk factors are relevant to multiple lines of business, sectors and geographies. Their full impact on the financial system may therefore be larger than for other types of risks, and is potentially non-linear, correlated and irreversible
  • Uncertain and extended time horizons: the time horizons over which financial risks may be realised are uncertain, and their full impact may crystallise outside of many current business planning horizons. Using past data may not be a good predictor of future risks.
  • Foreseeable nature: while the exact outcome is uncertain, there is a high degree of certainty that financial risks from some combination of physical and transition risk factors will occur.
  • Dependency on short-term actions: the magnitude of future impact will, at least in part, be determined by the actions taken today. This includes actions by governments, firms, and a range of other actors.

The magnitude of the financial risks from climate-related factors will depend on future scenarios that will, at least in part, be determined by actions taken today.

A ‘too little, too late’ scenario, where significant action is taken, but too late to achieve climate goals, could result in the most severe financial risks crystallising in the banking and insurance sectors.

Financial risks from climate change will be minimised if there is an orderly market transition to a low-carbon world, but the window for an orderly transition is finite and closing.

Expectations of companies

Though physical and transition are novel sources of shock, radical change to the physical environment, or sudden large changes in the value of assets which are financing activities that are incompatible in either their nature or their scale with a 1.5 or 2 degree rise in global temperatures will create financial risk through traditional channels such as market, underwriting and credit.

Liability risk too is a possible manifestation of risk from climate change, with the threat of litigation by those affected by climate change against companies and the directors of companies responsible for emissions.

This might be termed silent climate risk by analogy with silent cyber risk – exposure to cyber taken on not directly but unknowingly through various firms of indemnity insurance.

A key principle that the PRA is consulting on is an expectation that, because climate change-related shocks will manifest themselves through regular channels and are key risks to the firm, they should be managed as such.

This has many aspects, all part of our consultation. Strategy to measure and manage financial risks from climate change should be set at board level.

A key expectation is that firms will identify an individual at board level with the responsibility, under the senior managers regime, to properly measuring and manage its exposure to financial risk from climate change.

We are also proposing that the risk management function should embed consideration of risk from climate change into all measurements and risk management.

We recognise this is a big task, particularly on the transition risk side, as trying to estimate and manage exposure to these potentially unpriced tail risks is a subject in its infancy.

We do not expect firms to come up with solutions to this individually but to collaborate with each other and with us on building the machinery that will allow all regulated firms to meet our expectations.

This will lead, as and when more of this technology is developed, to a further consultation on expectations of risk management, with detailed specific expectations on firms to use the emerging risk measurement and management technology to prepare themselves for transition.

To this end the PRA and FCA are launching the Climate Financial Risk Forum, a small group of very senior level executives from bank, asset management and insurance sectors that will be responsible for commissioning and steering work to develop those techniques for the benefit of all.

This article is taken from the research report Insurance Asset Management – Europe 2019, which can be downloaded in full here.