UK: Climate-Related Financial Risks: The Next Regulatory Frontier

Opening a new chapter of the regulatory response to a transition to a low carbon economy, the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have set out their emerging approaches to supervising financial services firms' management of risks arising from climate change. Many of the regulatory focus areas around governance, risk management, scenario analysis and disclosure align to, and have already been set out in the UK Green Finance Taskforce report, the European Commission's in-flight legislative package on Sustainable Finance and the voluntary Taskforce on Climate-related Financial Disclosure (TCFD) guidelines. All that said, however, the publications represent a significant step towards requiring banks, insurers and investment managers to integrate climate change into their enterprise-wide risk management practices. We can now expect the regulators to clarify and finalise their approaches over the course of 2019.

In particular, the PRA's proposals make clear that viewing climate change solely as a corporate social responsibility issue is not sufficient for the banks, insurers and investment firms it regulates. But rather, climate change poses significant financial risk management challenges worthy of board-level attention. Boards' minds will have to concentrate on the proposal that firms should assign responsibility for climate-related risks to a Senior Manager. Furthermore, the proposal to include any material exposures to climate-related risks in the ICAAP or ORSA will compel firms to embed the identification of those risks into their risk management processes and strategic planning.

Background

As a founding member of the global Network of Central Banks and Supervisors for Greening the Financial System, the Bank of England (BoE) has been for some time at the forefront of the global supervisory debate on managing risks related to the transition to a green and low carbon economy. The BoE's methodology sets out the following risk categories:

  • Physical risks, which are caused by the increased frequency and severity of climate- and weather-related events.
  • Transition risks, which are generated by a sudden or disorderly adjustment to a low carbon economy. These can include any changes in corporate valuations due to capital re-allocation away from carbon-intensive industries and technologies, or any technological and policy changes that may affect firms' business models and asset valuations. Transition risks can lead to increased credit risk from some corporate borrowers.
  • Insurers' liability risks from people or business entities seeking compensation for losses they may have incurred from physical or transition risks.

PRA Consultation Paper

In its September report on the impact of climate change on the UK banking sector, the PRA identified that 90% of banks do not yet take a sufficiently forward-looking view on climate change and its long-term financial impact. Few banks have reviewed their board-level responsibilities to assign ownership of climate-related financial risks, or have actively assessed and mitigated risks at portfolio or individual counterparty level. As the PRA's consultation demonstrates, the often reactive and short-term lens through which many firms may view climate change cannot continue. In its proposed approach, the PRA has confirmed that banks, building societies, PRA-designated investment firms and insurers need to develop a strategic approach to managing the financial risks from climate change, and that includes undertaking a number of substantial changes:

  • Gaining board understanding and assessment of climate-related financial risks. The PRA expects firms to evidence that they have considered those risks in their risk appetite statements. In the PRA's view, firms should define clear roles and responsibilities for the board and its relevant sub-committees to manage the risks, as well as assign responsibility for identifying and managing them to the relevant existing Senior Management Function most appropriate in the context of the firm.
  • Identifying a risk management approach to climate-related risks. Not only should firms be able to evidence this in their written risk management policies, management information and board risk reports, they also need to include what they determine to be any material exposures in their ICAAP or ORSA, which should incorporate scenario analysis results (see below).
  • Using scenario analysis and stress testing to help with risk identification and to inform strategic planning. Firms should conduct forward-looking and data-driven exercises, in line with TCFD recommendations, to understand both the short- and long-term financial risks to their business model. As recognised by the PRA, using only past data may not be sufficient for such exercises, and a solution could be to utilise internal climate financial risk specialists or partner with industry organisations or peers to develop scenarios.
  • Mitigating any material financial risks that have been detected through scenario analysis. In such situations, the PRA would expect firms to develop a credible plan or policies for managing exposures, including potentially reducing risk concentrations. Solvency II insurers should also consider whether climate-related financial risks could cause their investment portfolios to fail the Prudent Person Principle, and may need, for example, to diversify their assets to avoid excessive concentrations of such risks.
  • Developing quantitative and qualitative metrics and tools to monitor financial exposure to climate change. This could include monitoring exposures to the physical and transition risks generated by climate change through firms' investment or lending portfolios.
  • Engaging with clients, counterparties and corporate investments to understand the current and future impacts of the physical and transition risk factors in order to inform risk assessment and management. Where appropriate, the PRA also encourages firms to aggregate asset-level data from publicly available sources or through collaboration with external organisations. As industry partnerships have identified that a bottom-up approach to assessing credit risks at a borrower-level is work-intensive and cumbersome, initially firms may choose to prioritise clients or counterparties from industries most vulnerable to climate change.
  • Considering whether Pillar 3 and Strategic Report disclosures provide sufficient transparency about climate-related financial risks, or whether additional disclosures are necessary. The PRA also places some expectation on firms to engage with initiatives such as the TCFD, to which over 150 financial services firms have committed.

FCA Discussion Paper

The FCA has also issued a discussion paper on climate change and green finance – its first dedicated to exploring the issues posed by climate change. The regulator is focused on "the impact of climate change on investments, and on all intermediaries in the investment chain", including any potential conduct risks for investors. As a result, the FCA proposes measures in four core areas:

  • Securities admitted to trading on a regulated market: to provide investors with information to make risk assessments on their investments and assess the impact of climate change on their securities' valuation, the FCA will be consulting on guidance to securities issuers about how the current disclosure regime might apply to climate-related risks. The FCA has suggested that this could take the form of a "comply or explain" approach.
  • Disclosure of climate risk management: in line with TCFD guidelines and the European Commission's proposal on sustainability risk disclosure, the FCA is seeking views on introducing a new requirement for firms to issue public reports on how they manage climate risks to their customers and operations.
  • Personal pension schemes: in Q1 2019, the FCA will launch a consultation to require personal pension schemes, including workplace personal pension schemes, to consider climate change in their investment decisions. Its upcoming consultation will also evaluate how Independent Governance Committees of workplace personal pension schemes take environmental, social and governance considerations into account, and introduce guidance for providers of workplace pension schemes to consider financial and non-financial factors when making investment decisions.
  • Innovation in specialist green products: to focus on the opportunities arising from a growing demand for green finance, the FCA has launched a Green FinTech Challenge to extend its Innovate services, including the regulatory sandbox, direct support and the Advice Unit, to select providers of green solutions and services.

Next Steps

The deadline for comments on both papers is January 2019, with the FCA then expected to consult on the specific measures above. Against a backdrop of many international and EU initiatives to put climate change onto the financial regulatory agenda, we can expect the UK regulators to take an active lead. They will also continue to collaborate with the industry through their new joint Climate Financial Risk Forum to explore a variety of relevant issues, including data improvement and the potential development of climate-related scenarios.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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