Bank of England to stress test climate change impact

The Bank of England is consulting on its proposals for stress testing the financial stability implications of climate change, by setting up a biennial exploratory scenario (BES)

The objective of the BES is to test the resilience of the largest banks and insurers to the physical and transition risks associated with different possible climate scenarios, and the financial system’s exposure more broadly to climate-related risk.

The Bank says that whilst climate-related risks will materialise over decades, actions today will affect the size of those future risks. It is therefore important that firms, and other stakeholders, continue to develop innovative approaches to measure climate-related risks before it is too late to ensure resilience to them.

The BES will use exploratory scenarios to size these future risks and to explore how firms might respond to them materialising, rather than testing firms’ capital adequacy.

The model will employ multiple scenarios that cover climate as well as macro-variables. These will test the resilience of the UK’s financial system against the physical and transition risks in three distinct climate scenarios, and will assess the implications of taking early, late and no additional policy action to meet global climate goals.

For insurers, this exercise builds on the scenarios developed for this year’s insurance stress test, but by widening participation to include banks, the Bank of England says it will be possible to see how the action of one sector will spill over to affect the other.

Since climate-related risks crystallise over a much longer timeframe than conventional risks, the BES proposes a modelling horizon of 30 years. It will include a bottom up, granular analysis of counterparties’ business models split by geographies and sectors in order to capture the exposure to climate-related risks accurately.

The output from the model will be used by the Bank of England to disclose aggregate results of the financial sector’s resilience to climate-related risk rather than individual firms. 

Mark Carney, Bank of England governor, said: ‘The BES is a pioneering exercise, which builds on the considerable progress in addressing climate related risks that has already been made by firms, central banks and regulators. Climate change will affect the value of virtually every financial asset; the BES will help ensure the core of our financial system is resilient to those changes.’

Sarah Breeden the executive director sponsor for climate change said: ‘None of us can know exactly how climate change will unfold, but we do know that it will create risks to the financial system. I am excited that this ground-breaking exercise will for the first time allow us to quantify this risk and so determine the actions we need to take today if we are to minimise these future risks.’

The Bank of England is consulting on the design of the exercise and welcomes feedback on the feasibility and the robustness of these proposals from firms, their counterparties, climate scientists, economists and other industry experts. The final BES framework will be published in the second half of 2020 and the results of the exercise will be published in 2021.

The deadline for comments is 18 March 2020.

The 2021 biennial exploratory scenario on the financial risks from climate change discussion paper

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