Taking stock: how is the UK banking sector responding to the challenge of climate risk?
June 2022
Managing climate-related financial risks has been a top priority on the UK financial agenda since the PRA published Supervisory Statement 3/19 (SS3/19) in April 2019, reaching a recent inflection point with the publication of the Bank of England’s Climate Biennial Exploratory Scenario (CBES) results. The new regulation has triggered a number of important developments in the industry - but major challenges remain, particularly around quantification and embedding. With the regulator now actively supervising climate risk and engaging with firms on progress, we take a look at how banks have responded and where there is work left to be done.
Governance - ensuring leaders can make informed decisions is crucial
Firms have, in general, adopted a top-down approach to SS3/19 requirements, prioritising aspects of governance such as board training and the allocation of Senior Management Function responsibility. As a result, the industry response in this area has been relatively strong. However, there is still some distance to travel:
- Although overall accountability for climate risk is usually clearly allocated, organisation-wide roles and responsibilities are often not yet fully defined and the tendency to view climate risk in a silo persists. This can lead to accountability gaps or failures to embed processes and controls appropriately outside sustainability teams.
Information given to boards and other key committees is often qualitative, even taking the form of project-style updates. Firms have struggled to integrate climate into risk appetite statements or develop consistent management information and risk metrics to ensure those charged with governance can make informed decisions.
Boards should be involved in the integration of climate into risk appetite statements; but firms are still grappling with how best to achieve this integration. Many statements remain high-level and only loosely linked to physical and transition risks.
There is a tendency for time horizons at board level to be too short-term, with insufficient attention given to long-term risks and opportunities.
Risk management - poor data quality holding back progress
The tendency towards a ‘top-down’ approach is also visible in risk management. Many firms have integrated climate risk into enterprise-wide risk management frameworks, often choosing to classify it as a primary risk. However, integration sometimes stops here, with firms failing to update more functional documents such as credit risk policies and procedures, lending and trading policies, and Risk and Control Self-Assessments.
Data is also an issue, which can limit firms’ ability to quantify financial risks from climate change and business model impacts with confidence:
- Risk appetite statements and climate-related management information should be supported by metrics and tolerance thresholds; but poor data quality means firms have struggled to achieve strong results in this area.
- Firms have started to perform portfolio-wide risk assessments and engage with key counterparties on physical risk and transition risk - but those counterparties often lack the data being asked for.
Scenario analysis - methodologies continue to evolve
Scenario analysis often starts out as qualitative but is subsequently supplemented with quantitative outputs, with modelling capabilities varying in sophistication and ranging from third party solutions to internal builds.
Despite this progress, a number of methodological issues remain. Shortcomings include:
- Lack of appropriate time horizons for assessing climate risk - primarily where firms have used shorter time horizons more applicable to macro-economic cyclical stress tests than climate transition pathways.
- Not using multiple scenarios (particularly ensuring at least one ‘transition risk’ scenario and one ‘physical risk’ scenario is used).
- Lack of granular counterparty or project-level data points (ie. geographical coordinates, emissions baselines) to enable precise analysis.
- Focussing scenario analysis solely on one risk stripe (ie. credit, operational, etc).
Disclosures - investment in metrics and targets is key
Leading firms have been disclosing in line with the Taskforce on Climate-related Financial Disclosures (TCFD) and other frameworks for several years and have developed a strong body of quantitative information to support their reporting. Others are yet to make their first full climate-related financial disclosures - although many will be required to do so in the near future as a result of new UK requirements.
There is significant overlap between the core SS3/19 requirements and the recommendations of the TCFD, which means that the UK industry as a whole should be well positioned to disclose its progress in the area. However, the amount of quantification underpinning disclosures will be highly dependent on data availability and the amount of investment firms have put into developing metrics and targets. End users will be able to quickly identify those firms which have been slow off the mark by the level of detail provided in published information.
Building on a strong baseline
Firms have - for the most part - been proactive in their responses to climate risk, building strong baseline capabilities around the SS3/19 requirements and TCFD reporting. Progress has been most visible in ‘top down’ areas like governance. However, the ability to quantify remains a major obstacle due to a lack of data, rapidly evolving methodologies, and capability gaps. Firms, regulators and other organisations should continue to work together to overcome these issues; this will enable the industry to build on its strong baseline and adopt more precise, robust climate risk management practices going forwards.
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