Climate change stress tests: the what, the when, and the how

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Climate change has become a topic of increasing focus across the re/insurance and wider financial sectors in recent years. It’s widely expected that climate change will impact insurability of properties, long-term investment decisions, product development, the ability to meet sustainability goals and more, with firms beginning to assess the impacts of climate change on their business.

This future risk focus is underlined further by regulatory moves from the Bank of England and equivalent organisations around the world. The UK Prudential Regulation Authority is due to issue its detailed climate change requirements in June. The Climate Biennial Exploratory Scenario (CBES) will require the largest UK life and non-life insurers, Lloyd’s syndicates, banks and building societies to assess the impacts of physical and transitional risk from climate change, with results due for submission in September.

Ahead of the CBES being released, many firms are beginning to consider what is required of them, as well as the data available. We’ve rounded up some of the top questions JBA is being asked by clients to help you start your own journey.

What is the PRA?

The Bank of England (BoE) Prudential Regulation Authority (PRA) regulates and supervises financial services firms. Regulation requires financial firms to hold sufficient capital and have adequate risk controls in place, and the PRA is responsible for supervising and regulating this in the UK for around 1,500 banks, building societies, credit unions, insurers and major investment firms.

What is the Climate Biennial Exploratory Scenario (CBES)?

Every two years, the Bank of England issues a Biennial Exploratory Scenario (BES), designed to test the resilience of firms to a range of less understood risks that are not neatly linked to the financial cycle. In 2021, the BES is being used to explore the financial risks posed by climate change, becoming the Climate Biennial Exploratory Scenario (CBES). It is a novel exercise for the Bank of England and participating firms, and will build on the work undertaken as part of the 2019 Insurance Stress Test.

The CBES will officially be launched in June, with results due for submission in September. The PRA will publish the results of analysis in Q1 2022.

Who needs to respond to the CBES?

The CBES will be testing the largest UK insurers as well as the largest banks and building societies.

Smaller firms are not required to complete the CBES. However, in a 2020 letter to the financial industry’s Chief Executive Officers, Deputy Governor for Prudential Regulation and CEO of the PRA, Sam Woods, expressed an expectation for all UK firms to have embedded their approach to climate change by the end of 2021. Furthermore, the Task Force on Climate-related Financial Disclosures (TCFD) recommendations are currently voluntary across the G20 member countries, but there has been discussion that this may become mandatory, and similar regulatory moves to the CBES are expected across the globe, including from the European Central Bank.

Therefore, while meeting the CBES is not a requirement for all firms, it’s good business to start considering climate change now regardless.

What is involved in the CBES?

Exact details of the CBES are yet to be released. However, we know that there will be:

  1. Multiple scenarios: firms will need to assess risk over three different climate scenarios, largely corresponding to a best case, worst case, and average scenario in terms of transition period and societal actions taken to combat climate change.
  2. Long-term modelling horizon: due to climate change impacts and policies taking place over a longer period, firms will need to assess risk over a 30-year modelling horizon compared to the usual short-term horizons. It is also widely expected for this 30-year time horizon to be broken down into shorter increments, such as 5- or 10-year time horizons.
  3. Physical and transition risks: firms will need to assess both physical risk, i.e. impacts of changes in physical hazard such as flood and subsidence on assets and books; and transition risk, i.e. moving to greener business and assets.
  4. Climate and macro financial variables: the Bank of England will provide firms with pathways for temperature, emissions and climate policies for physical and transition risks in each scenario, alongside macro financial variables to model the impact of the scenarios.
  5. Counterparty-level modelling: in order to assess the UK financial system as a whole, firms will need to assess the vulnerability of individual counterparties’ business models to climate risks in each scenario.

What data is available to meet the CBES and how can JBA help?

JBA and our partners can help firms to meet the CBES requirements, with an emphasis on physical risk. Flooding is one of the principle physical risks faced by businesses in the UK, and this risk is expected to increase in severity and frequency in future.

Our Climate Change Analytics (CCA) data suite can be used to assess potential changes in severity and financial cost of flooding for all RCP climate scenarios and for every 5-year time horizon from 2025 until 2100. The CCA complements our existing probabilistic UK Climate Change Flood Model, the first of its kind in the market, which estimates the frequency, severity and financial cost of flood by 2040 under a realistic 2 degree warming scenario. JBA can also provide change factors for data to meet specific CBES requirements.

Our team of specialists offer bespoke consultancy services for those clients who would like more technical advice or guidance, or who have specific needs beyond the CBES requirements, and our range of partners can provide non-flood physical risk information and transition risk insights.

Resources to help

We recognise that it can sometimes be difficult to know where to start, so the JBA team is on hand to help you understand the data available and how it can help you meet the CBES and other climate risk requirements. Fill in your details via the form above for your free eBook, helping you kickstart your journey.

We recently explored the CBES and what it means for the financial sector, especially mortgage providers, in a recent webinar with Mortgage Introducer. Watch the full recording here.

References

CBES information obtained from: https://www.bankofengland.co.uk/-/media/boe/files/paper/2019/the-2021-biennial-exploratory-scenario-on-the-financial-risks-from-climate-change.pdf?la=en&hash=73D06B913C73472D0DF21F18DB71C2F454148C80 

Sam Woods Dear CEO letter: https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2020/managing-the-financial-risks-from-climate-change.pdf?la=en&hash=A6B4DD1BE45B2762900F54B2F5BF2F99FA448424