Bank of England warns climate risks to become 'persistent drag' on profitability

A top HSBC executive may have downplayed the threat posed by climate risks, but the Bank of England's latest stress test exercise suggests financial firms' profits would be hit.

The timing may be entirely coincidental, but it makes it hard not to interpret it as a direct riposte. Just days after HSBC Asset Management's head of responsible investment Stuart Kirk offered a blistering critique of regulatory efforts to enhance the financial sector's climate risk management - "the amount of work these people make me do"; "markets are crashing around our ears today for nothing to do with climate whatsoever"; why are banks "being asked to look at something that is going to happen in 20 and 30 years hence"? - the Bank of England today published the results of its latest experimental stress test of banks and insurers' readiness for worsening climate risks.

Needless to say, Kirk, and those who agree with his complaint that financial regulation has lost its sense of perspective when it comes to climate risks, are unlikely to be impressed.

The report - which comes in the same week as a new analysis from Deloitte detailed how inaction on climate change could knock nearly eight per cent of GDP by 2070 - contains few surprises for anyone who has been tracking how climate risks are escalating and compounding.

Titled the Climate Biennial Exploratory Scenario (CBES) it assesses how 19 leading banks and insurers would cope under three different scenarios: an 'early action' scenario where rapid decarbonisation ensures warming peaks at 1.8C above pre-industrial levels before calling back to 1.5C by the end of the century; a 'late action' scenario where bolder climate policies are delayed by a decade but then an emergency effort to tackle emissions limits warming to 1.8C; and a 'no additional action' scenario where governments fail to introduce further decarbonisation policies and temperatures hit 3.3C of warming in the coming decades leading to "increasing and irreversible shocks… [whereby] UK and global GDP growth are permanently lower and macroeconomic uncertainty increases".

In a speech to mark the release of the report, BoE deputy governor Sam Woods warned that under all scenarios the climate-related risks faced by the finance sector are significant. "The first key lesson from this exercise is that over time climate risks will become a persistent drag on banks' and insurers' profitability - particularly if they don't manage them effectively," he said. "While they vary across firms and scenarios, overall loss rates are equivalent to an average drag on annual profits of around 10-15 per cent."

Some observers may be tempted to argue that a reduction in profits of around 10 per cent is entirely manageable, especially as economic growth works to enhance climate resilience. Indeed, this was the hypothesis at the heart of Kirk's controversial speech last week.

But Woods was this morning quick to counter that while under certain scenarios it is possible to envisage how climate change does not have a "worrying direct impact on [financial firms'] solvency", there are reasonable worst-case scenarios that could present a significant threat to financial stability. "Any positive message 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 said. "A world with climate change is a riskier one for the financial system to navigate."

Indeed, the report highlights how under the 'no additional action' (NAA) scenario the banks and insurers analysed could face total losses of up to £350bn pounds. Moreover, UK and international general insurers, respectively, would face a rise in average annualised losses of around 50 per cent and 70 per cent by the end of the NAA scenario. "It's worth emphasising that these costs would be mostly passed on to consumers through higher premiums," Woods noted.

The other big takeaway from the report, which again echoes the now huge library of academic work on climate risks, is that early action to cut emissions, enhance climate resilience, and manage climate risks is the most sensible course of action.

"Costs to the financial sector will be substantially lower if early, orderly action is taken," Woods argued. "For example, projected climate-related bank credit losses were 30 per cent higher in the 'late action' scenario than the 'early action' scenario. Among other factors, this reflects that in the scenario, adjusting late and abruptly to climate risk triggers a messy recession - with rising unemployment as the corporate sector adjusts… It will be in the collective interests of financial institutions to support counterparties that have credible plans to adapt - and ultimately reduce their exposures to those sectors of the economy that are inconsistent with a net zero policy."

Conversely, a failure to act brings with it significant direct and regulatory risks for financial firms. "To the extent that climate change makes the distribution of future shocks nastier, that could imply higher capital requirements, all else equal," Woods said, adding that a complex debate was on-going over when and whether new capital requirements may be required.

"Should climate risk be captured in capital requirements?" he asked. "In one sense, the answer is an obvious yes. Climate change will inevitably drive losses for banks and insurers - even in a scenario where governments around the world take swift and early action to bring us to net zero. Just as with any other risk, PRA-regulated institutions must have the resilience to keep serving the real economy in the face of these losses. Capital requirements are an important part of how we deliver that resilience.

"That said, while capital can address the financial consequences of climate change, we don't think it is the best tool to address directly the causes of climate change - for example by reducing capital requirements to subsidise 'green' assets, or increasing them to penalise carbon-intensive ones. How to address the causes of climate change is a decision for governments and parliaments, not financial regulators."

But what then of Kirk's complaints that the climate risk reporting requirements placed on corporates and investors are overly onerous and have lost their sense of perspective?

Woods' speech gives this school of thought short shrift. "Transitioning to net zero will be a major challenge for our institutions and societies even in a benign economic environment - doing so without confidence in the basic functioning of the financial system would be near impossible," he said. "It is therefore vital that firms can withstand risks to their safety and soundness, including those that arise as a consequence of climate change - both 'physical' risks like flooding and extreme weather events, and 'transition' risks that arise as the economy moves away from carbon-intensive activities. Firms therefore need to understand, at a granular level, how their balance sheets and business models are exposed to both present and future climate risks, so that they can take the right risk management actions today."

He added that such actions include "investing in their data and modelling capabilities, and carefully scrutinising the data they get from third parties. It means ensuring Boards and senior executives see climate risk as a strategic priority. And ultimately, it means ensuring firms hold sufficient financial resources to absorb losses arising from climate change". For the Bank of England, all those people at HSBC being forced to assess climate-related risks are doing vital work.

However, if there are few surprises contained in the Bank of England's stress test exercise, there is considerable uncertainty over what happens next.

Kirk may have reportedly been suspended by HSBC as the bank seeks to distance itself from his comments, but the government's recent Queen's Speech did quietly shelve plans for more robust climate risk and net zero transition reporting requirements. It remains unclear if the government is minded to strengthen reporting rules further and introduce more demanding capital requirements, despite it acknowledging that climate-related risks are intensifying.

David Barmes, senior economist at campaign group Positive Money, said the Bank of England's stress test simply "confirmed what we already knew, that delay to climate action poses severe costs to the economy". "Estimates suggest that financial markets are aligned with 3C of warming, so the Bank of England's prediction that banks should be able to survive temperatures peaking at 1.8C offers little comfort," he added. "The government and Bank of England must act fast to align the financial system with net zero. Outright restrictions on lending to new fossil fuel projects must now be on the table. At the very least, higher capital charges for unsustainable investments would force banks to cover their own losses when loans go bad, instead of falling back on the public purse."

Woods closed his speech this morning by presenting a similar challenge to government. "A key judgement will be: are current capital levels sufficiently high to guard against unexpected shocks during the transition? [And] even if capital levels are appropriate in aggregate, that does not mean that the capital is held in the right places. As we have seen, some of these risks are highly concentrated in particular sectors. A second key judgement will therefore be: does the framework of capital requirements capture climate risk at a sufficiently granular level?"

All of which presents a question as to whether or not banks are making sufficient progress in getting a grip on the climate related risks they face. "The CBES results show that while progress has been made, there is still much to do," Woods said. "From the point of view of capital, this suggests a third key judgement: are we satisfied that firms are building the capabilities they need - and if not, do we need to introduce more incentives?"

HSBC's Kirk may have argued last week that regulators had gone too far already in pushing banks to take climate risk seriously, but for the Bank of England there are clearly concerns that further action may be well needed. And somewhat ironically, Kirk's lifting the lid on how some financiers continue to privately dismiss climate-related risks could have made such interventions more likely.