Bank of England releases climate stress tests for financial institutions

The Bank of England (BoE) has released details of comprehensive climate stress tests for UK financial institutions.

The 2021 Biennial Exploratory Scenario exercise will examine 19 systemically important companies to explore the resilience of the UK financial system. It will assess physical and transition risks associated with different climate pathways over a 30-year time period.

Delayed by the pandemic, the BoE’s stress tests will include seven banks and building societies which account for 70% of UK bank lending. It will also cover 11 insurance companies representing the majority of both the UK’s life insurance and general insurance markets. Ten representative syndicates from Lloyd’s of London will also be assessed.

In a press release announcing the launch, the BoE presented the stress tests as an exploratory and learning activity only, making clear the information gathered will not be used to set bank capital requirements.

Financial institutions are expected to assess their climate-related risks and opportunities across three potential climate scenarios, based on those published by the Network for Greening the Financial System. The exercise will focus on bank credit books and insurers’ assets and liabilities, and will include detailed counterparty-level analysis.

Firms are asked to use “novel modelling approaches” to conduct a detailed, bottom-up analysis of their largest counterparties while exposures of smaller counterparties will be assessed by geography and sector. The exercise will also seek the participants’ views on their risks, climate risk management approach, and potential actions.

In response to the exercise, climate campaigners expressed concern at the BoE’s slow approach to active mitigation of climate risk and its threat to financial stability.

“It is concerning that the Bank of England appears to be ruling out using climate stress tests to help inform changes to capital requirements,” said David Barmes, senior economist at UK thinktank and advocacy group Positive Money. “Climate capital rules that reflect the high risk of fossil fuel investments are a necessary inevitability to ensure financial stability and alignment with the government’s climate plans, and the bank needs to be introducing such policies without delay.”

Barmes also expressed concern about the focus on understanding climate risk rather than on working to rapidly reduce greenhouse gas emissions. “These new modelling exercises, aimed at measuring the financial system’s exposure to climate risks, could be doing more to delay rather than accelerate regulatory action,” he said. “Climate risks are characterised by ‘radical uncertainty’ – their complex, far-reaching, non-linear, and rapidly evolving nature pushes them beyond the realm of quantification, meaning that modelling exercises will never be able to accurately measure them.”

Financial firms are expected to report their initial findings from the BoE’s climate stress test in the autumn, with a second round of stress testing due in January 2022. Aggregate results from the exercise are expected the following May.