On 26 September 2018, the Prudential Regulation Authority (PRA) published a report on the impact of climate change on the UK banking sector (Report). The Report examined the financial risks arising due to climate change and impacting PRA-regulated firms, assessed how PRA-regulated firms are responding to these risks and aimed to help them understand the PRA’s supervisory approach on such matters.
The Report’s key findings are set out below.
Financial Risks due to Climate Change
The PRA identified two types of financial risks arising from climate change, physical risks and transition risks.
- Physical risks can arise from climate and weather-related events, such as heatwaves, droughts, floods, storms and sea level rise and may, potentially, result in large financial losses, impairing asset values and the creditworthiness of borrowers.
- Transition risks can arise from the process of adjustment towards a low-carbon economy, including changes in policy, technology and sentiment and may, potentially, prompt a reassessment of the value of a large range of assets and create credit exposures for banks and other lenders as costs and opportunities become apparent.
According to the report these risks could potentially create or are already creating financial risks for the banking sector and undermine its resilience by increasing credit, market and operational risks. On the flip slide the report also briefly mentions climate-related opportunities, particularly relating to green finance.
The Banking Sector’s Response
The PRA conducted a survey covering 90% of the UK banking sector and representing over GBP 11trn in assets. Following this survey, it identified three broad categories which reflect how the PRA-regulated firms respond to financial risks arising due to climate change. More specifically:
- 30% of firms act ‘responsibly’ and adopt a corporate social responsibility perspective, focusing on reputational risks;
- 60% react ‘responsively’ and view climate change as a financial risk, however they also choose a more narrow, short-term perspective;
- only 10% of banks respond ‘strategically’, acknowledging the distinct nature and the unique challenges of climate-related financial risks and taking a forward-looking, long-term view on the basis of long-term financial interests.
According to the report, more institutions are expected to adopt the third, strategic perspective, as the risks from climate change become more prominent. In this respect, Mark Carney, Governor of the Bank of England (BoE), said that while “financial policymakers will not drive the transition to a low-carbon economy”, the BoE expects “regulated firms to anticipate and manage the risks associated with that transition”.
Overall, the survey findings point to an overall ‘transition in thinking’ on behalf of the banking sector with PRA-regulated firms enhancing their approaches to governance and risk management of the financial risks from climate change.
The Report concludes that, with strategic planning and an orderly transition to a low-carbon economy, financial risks associated with climate change can be addressed in an orderly, effective and productive manner. To this end, the PRA will publish a consultation on its supervisory expectations for banks and insurers; and will, jointly with the FCA, establish a new Climate Financial Risk Forum, to enhance the understanding of risks and suggest best practices in this emerging field.
The Financial Policy Committee, in its role of identifying, monitoring and taking action to remove or reduce systemic risks, will also consider the system-wide financial risks from climate change and explore whether climate-related factors should be included in a future Biennial Exploratory Scenario.