Net zero transition will be ‘bearable’ for UK banks under worst-case scenario, BoE finds

Capital requirements not the best tool for addressing climate change, says chief of UK prudential regulator, as UK central bank publishes second-round results of pioneering climate stress test.

The transition to net zero will be “bearable” for UK banks and insurers and should not involve “substantial impacts” on their capital positions, the second round of the Bank of England’s (BoE) pioneering climate stress test has found.

Launched in February, the assessment is a continuation of the BoE’s 2021 Climate Biennial Exploratory Scenario (CBES) stress tests, which marked the first time UK financial institutions were asked to submit projections on how their loan books and investments would be impacted by climate change.

In a report published on Tuesday, the BoE wrote: “Based on banks and insurers’ projections in this exercise, the overall costs to these firms from the transition to net zero should be bearable without substantial impacts on firms’ capital positions – for example through a combination of lower retained earnings and increases in lending rates to sectors where risks increase.”

Participating institutions – including the likes of HSBC, Barclays, Legal & General and Aviva – were asked to consider three 30-year scenarios in which governments act early to cut carbon emissions, government action is delayed or no action takes place. The scenarios are based on those developed by the Network for Greening the Financial System (NGFS), a coalition of central banks and regulators.

For UK banks, the stress test focused on their credit books, while for insurers the exercise assessed risks to both their assets and liabilities.

While financial institutions are likely to be able to absorb the costs of transition under all three scenarios, overall, the BoE found that costs would be lowest with early and well-managed action to reduce greenhouse gas emissions and so limit climate change.

Banks’ projected climate-related credit losses were 30 percent higher in the late action scenario than the early action scenario.

Losses in the late-action scenario were predicted to be approximately equivalent to an extra £110 billion ($138 billion; €128 billion) for the participating banks, with around 40 percent of the losses coming during the first five years of transition.

The study concluded that, if banks and insurers do not respond effectively, “climate risks could cause a persistent and material drag on their profitability”. This was estimated to be equivalent to an annual drag on profits of around 10-15 percent on average.

In a speech accompanying the publication of the results, Sam Woods, deputy governor for prudential regulation and CEO of the Prudential Regulation Authority, described the potential losses as “big numbers”. But he added: “By themselves, these are not the kinds of losses that would make me question the stability of the system.”

Woods cautioned, however, that “any positive message” taken from the report “needs to be taken with a major pinch of salt: both because there is a lot of uncertainty in these projections and because this drag on profitability will leave the sector more vulnerable to other, future shocks”.

He also rejected suggestions that capital requirements should be shifted to address climate change, either by reducing them for “green” assets or increasing them to penalise carbon-intensive ones.

“At worst, we might end up under-capitalising banks and insurers for the risks they face, raising questions about their overall resilience. Or we could end up over-capitalising them inefficiently, reducing their ability to support the economy through the transition,” Woods said.

In February, the BoE announced an upcoming conference in Q4 to explore the issue of adjusting capital adequacy requirements to take account of climate-related financial risks. The central bank also called for papers on the topic.

Limitations around data were a “recurrent theme across participants’ submissions”, the BoE reported. As a result, the central bank called on banks and insurers to “prioritise investment in their climate risk assessment capabilities” in order to produce better estimates of climate risks in their portfolios.

For instance, BoE found that “few” banks have developed in-house modelling capability, with “many reliant on a small number of third parties”. Moreover, it found that banks “varied in their ability to scrutinise and understand the strengths and weaknesses of third-party models, and adapt them appropriately to the CBES scenario”.

Examples of data gaps include information about the location of corporate assets, which would be required to assess physical risks.

The CBES report also found that around a fifth of participating banks’ most significant corporate exposures are to “counterparties which another participating bank also had a lending exposure to”. It noted that banks “projected substantially different loss rates on such shared counterparties”.

The BoE also raised concerns about cutting off finance to high-emitting firms too quickly. “[T]here could be potential macroeconomic consequences if limits in the supply of finance and insurance to fossil fuel producers could outpace the new investment in sustainable energy alternatives and improvements in energy efficiency,” the bank wrote.

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