The Climate Biennial Exploratory Scenario or CBES: not just another acronym!
In May 2022, the Bank of England (BoE) published its findings from it first exploratory scenario exercise on climate risk, run with the UK’s largest banks and insurers during 2021. So, other than being the first of its kind, why should you be interested in these findings?
Stress testing the financial system allows central banks to examine whether the financial system has the necessary resilience to withstand shocks. In this specific scenario, the test was how the system would withstand the risks arising from climate change. As such, the results provide insight for firms, regulators and government and should help inform their current decision-making and risk management.
The climate scenarios used by the BoE are based on those developed by the Network for Greening the Financial System. Designed to support central banks bring greater consistency and comparability to stress-testing exercises they examined climate-related financial risks that might unfold over the next thirty years. Two routes to meeting the net-zero carbon dioxide emissions targets by 2050 were considered: an Early Action scenario and a Late Action scenario. A third scenario explored what might happen in terms of the physical risks materializing if governments around the world fail to take action to address climate change: the No Additional Action scenario.
Using the description given by Sam Woods (Deputy Governor at BoE and Executive of the Prudential Regulatory Authority), the Early Action scenario is where climate policy is ambitious from the beginning. It envisages a gradual intensification of carbon taxes and other policies over time resulting in global warming (relative to pre-industrial levels) being successfully limited to 1.8°C by the end of the scenario (2050) and falling to around 1.5°C by the end of century.
The late action scenario brings a far less optimistic future. Here policy measures are delayed by a decade, and then are implemented in a sudden and disorderly way. Global warming is limited to 1.8°C but only by the end of the scenario (2050) and then remains around this level at the end of the century.
In the no action additional scenario, governments around the world fail to enact any new policy measures to address global warming. As a result, global temperature levels rise by 3.3°C relative to pre-industrial levels by the end of the scenario. Unsurprisingly, this leads to serious, often irreversible, environmental impacts, including extreme weather events, destroyed ecosystems and rising sea levels. If this plays out, UK and global GDP growth are projected to be permanently lower and macroeconomic uncertainty increases.
It's important to note that these scenarios were devised and run before recent political and global events. They cannot therefore be considered the ‘worst cases’ since they do not include the potential for additional losses caused by, for example, mass migration or conflict.
Despite the lack of certainty around climate policy roadmaps and technical advancements that might manifest during the projected timescale, it was reported that UK banks and insurers are likely to be able to absorb the costs of transition to net zero – although the forecasted levels of climate losses are uncertain. That said, this is in part because a significant portion of these costs could be passed on to their customers. The CBES results suggest that climate change risks could reduce profits by an average of 10-15% - or, as Sam Woods puts it, could result in ‘a persistent drag’.
Whilst progress in many key areas has been made, it is data and modelling, including variance in quality, that preoccupies the findings. The Bank notes the reliance of the sector on only a few third parties to resource this skillset, and few banks building their internal capacity to model risks. Taken together with ongoing uncertainties, banks should invest in the skills and expertise to understand better the impact of climate risk and transition risks, not only in the context of those areas in relation to these scenarios but more broadly, such as market risk.
Banks are also encouraged to take early action and support the transition of the wider economy by supporting adaptation of highly exposed counterparties with credible transition plans, gradually reducing their exposures.
Well evidenced in the report is the fact that: ‘Around one fifth of participating banks’ most significant corporate exposures are to counterparties which another participating bank also had a lending exposure to.’ This indicates some systemic concerns arising. Readers that enjoy more visual reports are directed to section 4.1 of the results. Here, the projected impact on banks of realised loss rates – which rise for all 3 scenarios – is outlined. It comes as no surprise that, when taken at a sectoral level, it is the carbon intensive sectors which account for the greatest exposure.
Within the retail lending sector, a significant issue is again data – this time as regards the state of the UK’s housing stock. This is of particular concern in context of the late action/no action scenarios. Lack of data around energy performance certificates (EPCs) and the ability to assess/model non-flood risks over the longer term are highlighted. This may be a valuable lesson for those smaller lenders not included in the CBES but with a large mortgage book. The message seems clear that as a sector it is not enough to know your customer, but to urgently start thinking about how climate change – and perhaps more broadly, the transition to a net zero economy will impact them.
We’re proud to support so many of our members have already started asking themselves these questions and are now developing and maintaining the skills, knowledge and confidence to ask the right sustainability questions of their clients and customers. In this way, we hope they and their colleagues can meet the challenges identified through this exercise and apply their professional skills and judgements as soon as possible to drive and support their banks’ and their clients’ transition plans.