Although the green transition could substantially reduce the profits of banks and insurance firms, they are likely to be able to bear these losses in part by passing them onto their customers, the Bank of England (BoE) has projected following its first climate stress test.
The BoE has made the projection in a much-anticipated report outlining the findings of its 2021 climate biennial exploratory scenario (CBES), an exercise to assess the ability of the largest UK banks and insurers to withstand the physical effects of climate change and the transition to net-zero. The CBES tested institutions under three scenarios in which early, late or no additional action is taken against climate change.
It found that households and businesses would be especially hard hit in the event that no further action is taken to mitigate rising temperatures, as insurers would pass on the cost of higher claims into premiums, or otherwise refuse to renew insurance for some customers.
The hit to banks’ profits could be as much as 10% to 15% if they fail to properly manage climate risks, the BoE warns. Institutions could also face higher capital requirements, as regulators would want to ensure they are sufficiently resilient to keep serving the real economy in the face of mounting losses. However, the BoE has signalled that it has no immediate plans to amend its capital framework following the exercise.
BoE deputy governor Sam Woods said the benefit of early action was the “first lesson” from the CBES. He also stressed that despite the size of the projected losses, the limits of the exercise mean the actual impact could well be larger.
“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 warned.
Given the BoE’s acknowledgement of the methodological limitations of the CBES and the difficulties quantifying the multidimensional risks banks face, climate advocates have criticised the central bank for failing to significantly alter its current approach to supervision.
Lukasz Krebel, an economist at the New Economics Foundation, tweeted that despite the wide error bands in the CBES modelling, the BoE seems to have concluded that beyond more research, data gathering and conversations with banks, not much more needs to be done.
Academics have long argued that instead of relying on inadequate methodologies to try and measure climate risks, central banks should take a precautionary approach towards addressing them. This would involve proactively steering financial institutions towards a managed transition, so as to minimise harm to the financial system and the wider economy in the future.
The BoE has announced it is investigating how its capital framework might be changed to better reflect climate risks and is hosting a conference on the issue later this year. However, Woods argued that it is not the bank’s job to address the causes of climate change by penalising lending towards polluting sectors. He said that doing so would come with significant risks and would be unlikely to achieve its intended goals, pointing to the limited impact of similar initiatives undertaken previously elsewhere.
Krebel suggested that even if capital requirements were imperfect for this task, the BoE should be using all of the tools at its disposal to tackle climate change. He said the bank’s inaction on curbing dirty investments is fuelling future risks, and backed calls for the introduction of a ‘one-for-one’ rule for the financing of new fossil fuel projects, meaning that banks would have to do so solely from their own funds.
The scenarios used in the CBES have been developed by the Network for Greening the Financial System (NGFS) and built upon by the BoE. Some of the NGFS scenarios have been criticised for containing unrealistic assumptions about the impacts of unproven carbon capture and storage technologies, and the unsustainable use of biomass for energy production.
The BoE report says that, given the challenges facing carbon sequestration technologies, its scenarios assume that nothing beyond a moderate level of sequestration can be achieved by private and public investment in this area.
This page was last updated May 26, 2022
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