Results from the BoE Climate Biennial Exploratory Scenario

Almost a year after the Bank of England’s launch of their Climate Biennial Exploratory Scenario (CBES), results have been published. We have summarised the key observations. In a follow-up paper, we will summarise the key learning points from the exercise and what might come next.

The state of play

Banks

Banks have made notable progress in:

Integrating climate risk into their risk governance and management structure and reporting framework
Identifying their portfolios which may be most sensitive to climate risks

However, they face challenges in accurately quantifying the level of risk they are exposed to. Their overall ability to model climate risk is at an early stage. Few banks have developed in-house modelling capability, with many relying on a small number of third parties.

Progress in relation to risk appetite and risk assessment has been significantly hampered by a lack of standardised data of sufficient quality to underpin the measurement, assessment, and modelling of climate-related risks.

Insurers

Insurers have also made notable progress in incorporating climate risk into their existing risk governance frameworks. However, it has been noted that they still face numerous data challenges which make it difficult to estimate potential losses on their invested assets.

The ability to assess and model physical risks in the CBES varied across firms, largely reflecting their varying capability to modify existing models.

Firms’ exposure to climate-related risks

Banks

Projected total corporate loss rates from individual banks spanned a wide range, with the highest estimates typically being around twice as large as the lowest across scenarios.

Projected bank credit losses were greatest in the Late Action scenario.

Projected climate risk impacts were highest for banks’ wholesale and mortgage exposures, where projected climate-related consumer credit losses were relatively low. Mortgage losses are highest in the Non-Additional Action (NAA) scenario, and these losses are geographically concentrated.

Some of the most carbon-intensive industrial sectors, and those most exposed to physical risks, account for a disproportionate share of projected corporate credit losses.

Insurers

Insurers’ projected losses spanned a wide range, in common with those of banks. Insurers projected a rise in average annualised losses of around 50% on UK exposures, and 70% on US exposures, by the end of the NAA scenario, although staff analysis suggests these losses could be significantly higher.

In the NAA scenario, losses on insurers’ investment assets were largest and projected UK general insurance losses were highly geographically concentrated.

Life insurers account for the majority of projected investment losses. Not all investment losses fall on shareholder funds, and as a result the impact on insurers’ solvency positions is likely to be manageable.

Insurers and banks identify similar corporate sectors as being most at risk to transition and physical risks, and therefore losses are presented as concentrated in some more carbon-intensive sectors (mining and manufacture of petroleum, and electricity supply).

Some firms under-calibrated physical risks compared to prescribed benchmarks.

Firms’ responses to climate-related risks

Transition risk scenarios, i.e. Early Action and Late Action

In the Early Action and Late Action scenarios, banks planned to increase lending substantially to some components of the gas and electricity supply sector, specifically to renewable energy firms.

On the retail side, banks planned to offer green mortgages and provide financing products for home energy efficiency improvements.

General insurers planned to expand further into opportunities that would be created by a net-zero transition. Life insurers, however, quantified fewer concrete new opportunities as part of the shift in their investment portfolios in this exercise.

Considering responses from banks and insurers together, these strategies raise the possibility that some corporate sectors (particularly some carbon-intensive ones) may struggle to access finance as the transition progresses, especially from banks. This is a point of note that governments should consider when developing future policies or creating incentives towards green finance.

Physical risk scenario, i.e. No Additional Action scenario

Banks and insurers envisaged far fewer new opportunities in the NAA scenario in comparison to the two transition scenarios. This is probably reflective of the fact that macroeconomic prospects at the end of the scenario are much worse.

Banks planned to reduce new lending secured on properties facing higher physical risk in the NAA scenario. Meanwhile, general insurers planned to increase the price of insurance in line with the increases in physical risk in the scenario.

Background

In June 2021, the Bank of England launched its first round of climate stress testing to better understand the financial risks from climate change. This was followed by the second round in February 2022 where participating banks and insurers were asked to provide further information.

The first round of the BES exercise aimed at testing the resilience of the current business models of the largest banks and insurers, and the financial system to the physical and transition risks from climate change. The second exercise further explored participants’ strategic responses to the three scenarios published as part of the first round and the associated implications for their business models.