Bank of England turns its focus to climate risk at UK banks

The Bank of England is initiating a review of the impact of climate change on UK banks, as part of broader efforts to prevent financial instability caused by rising global temperatures. In its first “topical article” on climate change, the UK central bank has said it is taking a “forward looking approach” to assessing the issue, “with a view towards early intervention”.

It comes as Swedish state pension fund Sjunde AP-fonden (AP7) has excluded six fossil fuel firms – including Exxon Mobil – for violating the Paris climate accord.

The Bank of England document, published today and titled: The Bank of England’s Response to Climate Change, says although there are some implications for monetary policy – like volatility in headline inflation caused by spikes in food and energy – the BoE’s main driver for analysing climate change was its “responsibilities to promote the safety and soundness of regulated firms and to maintain financial stability”.

The bank has already undertaken work on climate risk in the insurance industry, but will undertake more granular research at firm-level, it says. It will also consider the relevance of climate-related factors to the existing supervisory approach of its regulator, the Prudential Regulation Authority (PRA), including stress testing and business model analysis.

In addition, it is to kick start a similar “internal review of the impact of climate change” on banking institutions regulated by PRA. This will include internal research and engagement with firms via meetings and surveys, it said.

In the document, the BoE identifies financial risks beyond monetary policy, such as added pressure on bank lending and sovereign risk profiles globally.

It reiterated that it was assessing climate change both in relation to the economic risks posed by physical damage (as a result of natural disasters, for example), and those that might arise from the transition to a low-carbon economy (such as carbon taxes or technological advances).It is also looking at the issue of liability, in the case of parties claiming compensation as a result of climate-related losses.

“Climate change, and society’s responses to it, present financial risks which impact upon the Bank’s objectives,” the bulletin explains.

The document comes ahead of the much-awaited report of the Taskforce on Climate-related Financial Disclosures next month, an initiative driven by BOE Governor Mark Carney.

Physical risks can cause large financial losses through damage to real assets which – if uninsured – “could also result in economic disruption at a national level, reducing tax revenues and increasing fiscal expenditures. This, in turn, could lead to an increase in sovereign default risk and have a negative impact on GDP,” the report says. Insured risks could put major strain on the insurance sector and public insurance cover. Banks lending against properties that are damaged as a result of natural disaster may also face increased pressure as a result of those financial losses, it said.

“Looking forwards, there is evidence to suggest that, alongside other factors, rising global temperatures will significantly increase overall exposures to physical risks,” it concludes.

On the transition side, changes to climate policy, technology and market sentiment “could prompt a reassessment of the value of a large range of assets as changing costs and opportunities become apparent”, it observes, adding that the timeframe for these changes are unclear, but “could be important for financial stability and the safety and soundness of financial firms”. It pointed out that the use of modelling beyond five years by financial firms can be “limited” and that environmental factors are not fully integrated into decision-making at financial and corporate level.