With a nod to Green Great Britain Week, the PRA have recently published a draft supervisory statement for consultation that outlines its proposals for addressing the financial risks arising from climate change. The statement is directed at both Banks and Insurers. This note summarises that consultation and speculates on the direction of travel from here.
At the heart of the PRA’s outreach lies a sober piece of risk mitigation: climate change presents a significant challenge for the financial services industry. The PRA categorises the financial risks that a firm faces from climate change into two types – “Physical Risks” and “Transition Risks”. These can be summarised as follows:
- Physical risks from climate change, such as an increase in floods and storms, can directly affect insurance firms if the losses are insured. The losses from natural disaster events in 2017 were the highest ever recorded. Inflation adjusted insurance losses from such events have increased from around $10bn in the 1980s to around $55bn over the last decade. This is a problem that is clearly on the rise. If such losses are not insured, then their burden can fall onto households and companies, impairing asset values and thereby increasing credit risk for lenders.
- In addition to these Physical Risks, Transition Risks can emerge as the world heads towards a low-carbon economy. The PRA cites the example of UK properties that cannot be let if their energy performance certification is not above category F (the sixth lowest), making any buy-to-let loans secured on such properties more likely to default. Risk assessments clearly need to contemplate how future risks of this nature could evolve.
Draft Supervisory Statement
The PRA acknowledge that the horizon for climate change is uncertain and that supervisory practices are still evolving. With this in view, they have deliberately set their proposals at a high level in order to provide sufficient scope for best practice to emerge, albeit within a set of broad principles. The PRA expects firms to develop an approach that is proportionate to the nature, scale and complexity of their business and that it should cover the following areas:
- Governance - A firm’s board should be able to understand and assess the financial risks from climate change that affect them and be able to assess and oversee these risks within the firm’s overall business strategy and risk appetite. Where appropriate, the PRA expects to see evidence of this oversight and how risks have been monitored. A clear governance structure should be put in place and, in particular, the appropriate Senior Management Function(s) with responsibility for identifying and managing financial risks should be identified.
- Risk Management – Firms should be able to address climate change financial risks through their existing risk management frameworks - in line with their board-approved risk appetites. They should recognise that managing these risks requires a long-term, strategic approach and that policies should cover (1) Risk Identification and Measurement; (2) Risk Monitoring and (3) Risk Management and Mitigation.
- Scenario Analyses – Firms should conduct scenario analyses that model the impact of financial risks arising from climate change on their overall risk profile and strategy across a range of outcomes. A scenario analysis should also address the Transition Risks arising from the possible paths to a low-carbon economy. The respective frameworks of ICAAP for Banks and ORSA for Insurers are suggested templates for assessing the financial risks arising from climate change.
- Disclosure - a firm’s Pillar 3 should disclose the extent of their compliance with the PRA’s supervisory statement and also additional climate risks that are not addressed therein. This is consistent with their existing obligations under the CRR and Solvency II to disclose information on material risks. Significantly, the PRA expects firms to engage with wider initiatives on climate change and take into account disclosures that are comparable across firms – for example the Recommendations of the Task Force on Climate-Related Financial Disclosures.
The consultation closes for responses on 15 January 2019.
The PRA’s consultation on Sustainable Finance-related supervisory practices reflects the growing prominence of these issues within financial markets. Indeed, NWM investor surveys suggest that 84% of investors already include Environmental, Social and Governance (“ESG”) issues in their decision making and that European institutional investors are keen to improve their sustainability reporting.
In addition to the PRA’s guidance, the FCA have also shared their thoughts on climate change and green finance supervisory matters. The FCA has also recently launched a Green FinTech Challenge with a view to identifying suitable FinTech candidates that require regulatory support in their development of products that will help transition the UK to a greener economy.
Beyond the UK, there are other initiatives that support the increased importance of ESG. For example, legislation has existed in France since 2016 that obliges investors - including asset managers, pension funds and insurers – to report how they integrate ESG into their investment policies. Efforts are also afoot to investigate a European-wide regulation that could standardise ESG disclosures.
Viewed in the round, the sea level of Sustainable Finance continues to rise. Eventually, it will find a high tide, but, for now, there is every reason to keep abreast of its swell.