The Bank of England has launched its first stress test of the largest banks and insurers to assess and understand the risks posed by climate change in the financial sector.
The Climate Biennial Exploratory Scenario (CBES) will explore the two key risks from climate change – the impact of the move towards a net zero economy, i.e. the ‘transition risk’ and risks associated with higher global temperatures likely to result from taking no further policy action, i.e. the ‘physical risks’.
It will explore the vulnerability of current business models to future climate policy pathways and the associated changes in global warming, helping identify the potential risks posed to those business models over time.
The UK’s seven biggest lenders are taking part, including Barclays, HSBC, Lloyds Banking Group and NatWest Group, life insurers including Aviva, Legal & General and Phoenix as well as large general insurers including Allianz Holdings, AXA and Direct Line.
The test, which will be carried out every year, is only “exploratory” and will not be used by the banks to set capital requirements against the risks.
Instead, participants’ submissions may inform the Financial Policy Committee’s future approach to system-wide policy issues and the Prudential Regulation Authority’s (PRA) future supervisory approach.
The Bank of England intends the CBES to be a “learning exercise” as experience and expertise in modelling climate-related risks is still relatively immature.
Andrew Bailey, Governor of the Bank of England said: “Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole. It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks.
“It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”
The Bank expects to publish the results in May 2022.