Climate change has been a topic of discussion for a number of years, with consumers, vendors, financial services firms and investors keen to implement their personal and ethical views on their choice of financial products, culminating in “green bonds" and other “green" initiatives and products in the last few years.
It is widely agreed that climate change presents a tangible risk to the financial services industry, with the Bank of England publishing an article on its response to climate change in June 20171 following the Prudential Regulation Authority’s (PRA) comprehensive paper on the impact of climate change on the UK insurance sector in September 20152.
With the above premise in mind the PRA published a consultation paper and draft supervisory statement on banks’ and insurers’ approaches to managing the financial risks from climate change. The purpose of the paper is to set out how effective governance, risk management, scenario analysis and disclosure may be applied by regulated firms to address the financial risks from climate change.
The PRA is seeking to have firms take a more strategic approach to managing the financial risks from climate change by taking into account the level of current risks, risks that can reasonably forseeably arise in future and identifying the actions required today to mitigate current and future risk. The PRA noted that the banking and insurance sectors have significant differences in the level of maturity of firms’ responses to financial risk from climate change, as only a few firms have adopted a strategic approach to these risks.
The PRA notes that financial risks from climate change can arise through three different risk factors, physical, transition and liability. Physical risks arise from events such as specific weather events and longer term shifts in climate, and transition risks arise from the process of adjustment towards a low-carbon economy and developments in policy and regulation. Liability risks arise for parties who have suffered loss or damage from physical or transition risks and are seeking to recover losses from those they hold responsible. The financial risks are distinctive and unique in that they can have significant implications, have uncertain or extended time horizons, are foreseeable in nature in that, while the exact outcome (and extent) is uncertain, there is a high probability that financial risks from some combination of physical and transition risks will occur. In addition, actions taken today by governments, firms and consumers will affect future impact.
The PRA is proposing that firms address these financial risks through their existing risk management framework in line with their general risk appetite and in a way in which it is proportionate to the nature, scale and complexity of their business. The PRA may seek evidence of how firms are monitoring and managing such risks in the form of the firms’ risk appetite statements, as the PRA expects firms to understand the nature and scope of such risks on their business model. As such, the PRA expects firms to have clear roles and responsibilities for the board and its relevant sub-committees in managing these unique risks.
The full copy of the consultation paper and supervisory statement can be found here.