The Bank of England (BoE) announced today the results of the Biennial Exploratory Scenario (BES) exercise, its stress test aimed at assessing financial risks from climate change for UK’s large banks and insurers. The exercise indicated that banks and insurers in the UK are likely to be able to absorb the transition and physical costs of climate change, but will likely face significant financial headwinds, particularly if action to address climate change are insufficient or delayed.

The test results also indicated that consumers and businesses will bear much of the burden of climate change, as banks and insurers will likely pass on many of the costs to their customers, with households and companies vulnerable to physical climate risks hit the hardest.

The BES was designed to explore the climate-related risks facing the financial institutions, including both transition risk, or those arising from the significant structural changes to the economy needed to achieve net zero emissions, as well as physical risks, or those associated with the impact of higher global temperatures.

The test used three scenarios based on those prepared by Network of Central Banks and Supervisors for Greening the Financial System (NGFS), including ‘early action’ (EA), ‘late action’ (LA) and ‘no additional action,’ (NAA) which highlight a range of outcomes encompassing scenarios that follow the most efficient pathway to net zero, as well as those from pursuing late or insufficient action.

In a speech to the Global Association of Risk Professionals following the release of the stress test results, Sam Woods, Deputy Governor for Prudential Regulation and Chief Executive Officer of the Prudential Regulation Authority, outlined the key differences of the sets of scenarios:

“Broadly speaking, the first two scenarios focus on risks from the transition to net zero, whereas the third one focuses on physical risks from climate change. And to reiterate a theme I will come back to later, the risks from climate change have been managed by the end of the first two scenarios – whereas in the third they continue to build.”

The test results indicated that banks and insurers would likely be able to absorb the transition and physical costs of climate change without facing material solvency risk. The impact on climate risk on profitability are likely to be significant, however, with loss rates leading to an average 10-15% annual drag on profits.

The degree of losses and risk indicated by the test vary significantly with the timing and extent of climate action, with climate-related credit losses for banks under the late action scenario 30% higher than the early action scenario. Loss rates for banks under the late action scenario were projected to more than double as a result of climate risk, leading to  an extra £110 billion of losses.

While loss rates under the no action scenario were actually lower than the late action scenario over the 30-year horizon of the test, the BoE noted that the NAA scenario carries substantially higher long-term risk, particularly outside of the test’s timeframe. Additionally, in contrast to the action scenarios, the NAA scenario does not provide the organizations with the opportunity to reinvest profits in transition opportunities.

Woods said:

“Under both the LA and EA scenarios, climate change has broadly been brought under control by the end of the 30 year period. By contrast, with no additional action the impacts will persist well beyond the 30 years of our scenario – incurring substantial economic costs not captured in these estimates.”

The test also indicated that climate vulnerable households and sectors would be particularly impacted under the NAA scenario, as assets exposed to physical climate risk could become prohibitively expensive to borrow against or insure. Homes in areas at risk of flooding, for example, could ultimately become uninsurable.

Woods noted that the BoE was encouraged by the progress banks and insurers have made in their climate risk management, and highlighted key feedback themes for participants in the test, including the need for more data on customers’ emissions and transition plans, and the need to invest in modelling capabilities, and to consider strategic responses to the implications of different climate policy pathways.

Woods added:

“Today’s exercise explores how well they are equipped to manage the longer-term challenges from climate change, in the context of our financial stability objective. We find that they are likely to be able to absorb the climate costs which fall on them without material risks to solvency, but will face significant headwinds and therefore need to continue to invest in their ability to support the economy’s transition to net zero.”