Maintaining Momentum: Managing Climate risk in a changing world − speech by David Bailey

Good morning.

Ten years ago, the Bank of England publicly warned that climate change presented a new type of challenge for the financial system.^{footnote [1]}

Both the physical and the transition risks we identified at the time are a decade advanced and pose a growing threat to the firms we regulate. For example, the crystallisation of physical risks can be seen in recent weather disasters, such as the floods which struck Spain last October, the European heat wave in 2022, and unprecedented flooding in Pakistan^{footnote [2]} that affected a third of the country and had a significant economic impact^{footnote [3]}. More recently in California, the estimated cost from historic wildfires in January this year ran into the hundreds of billions of dollars^{footnote [4]}.

Attributing the cause of natural disasters is a difficult science, but it is increasingly clear that climate change is influencing the likelihood and severity of such events. In 2023, the Intergovernmental Panel on Climate Change (IPCC) stated, with high confidence, that human-caused climate change has led to widespread adverse impacts with related losses and damages to nature and people^{footnote [5]}. The economic and insurance exposures in high-risk regions are therefore likely to continue to grow in parallel with climate change.

For the banks and insurers that we regulate at the PRA, these risks can directly affect their ability to support clients. That includes firms that need to transition away from fossil fuels, but also those that are exposed to the broader transition risks coming from changes in government policy and consumer behaviour. This may, in turn, put pressure on banks’ and insurers’ own commercial resilience as losses crystalise.

For regulators, like the PRA, climate change matters both from a risk perspective and in terms of the financial sector’s ability to support the wider economy. Effective risk management at firms will help create a more resilient financial system that can withstand the increase in the frequency and severity of climate events that we are experiencing and any changes in the transition pathway. This is essential for supporting both the sustainable growth and the competitiveness of the UK economy over the medium to long term.

That’s why in 2019 the Bank of England was one of the first central banks to create supervisory expectations for how the firms we regulate manage climate-related risks. We issued Supervisory Statement 3/19^{footnote [6]} to guide banks and insurers in their approach to managing the financial risks arising from climate change, as they were understood at the time.

Since then, there has been a concerted effort involving industry and regulators, both domestically and internationally, to create a shared framework for assessing and managing climate risk. Firms have worked, through fora like the Climate Financial Risk Forum (CFRF), to embed our expectations and have made progress in many areas. We have not stood still either, offering firms guidance through publications like our Dear CEO^{footnote [7]} and Dear CFO^{footnote [8]} letters, our exploratory climate stress test (CBES) exercise^{footnote [9]}, as well as our periodic Climate Change Adaptation Reports^{footnote [10]}.

But there is still more to do, and it remains critical that firms continue to focus on these risks. To this end, we signalled last year that we would commence work to update our supervisory expectations to incorporate the lessons we have learnt over the last 5 years.

Today marks the opening of the consultation window for those updated expectations, and I wanted to provide some further insight on what we are trying to achieve.

The first thing to clarify is that these are expectations, not rules. They are enhancements to our previous expectations set out in SS3/19 and do not represent a change of direction in our approach to climate risk.

The proposed expectations consolidate and clarify the feedback that the PRA has provided publicly on climate risk since SS3/19 was published. They will align our approach with the relevant international standards for insurers and banks in a way which is consistent with the PRA’s objectives. And they will bring our guidance up to date by adding detail to those areas where our understanding of best practice has matured.

One area in which our understanding has developed significantly is scenario analysis. Climate related risk management practices cannot rely on historic data in the same way as for traditional risks. But there is still a degree of predictability about the potential economic impact of climate change. This reinforces the importance of scenario analysis as a key tool for all firms, and we have worked with both the Network for Greening the Financial System (NGFS) and the Basel Committee on Banking Supervision (BCBS) to explore the different applications of scenarios for risk management purposes.

In our updated expectations, we therefore place greater emphasis on the rigorous use of scenario analysis. Firms will be expected to show a strong understanding of how they will take the outputs from the scenarios they design and construct and use them to actively inform the business decisions they take.

Developing scenario analysis to actively inform decision making also requires firms to overlay their own judgement and risk appetite, as they know their own businesses the best. Therefore, we have stressed the need for further integration of climate risk into firms’ governance frameworks.

Another area in which our expectations have been developed is in stressing the need for firms to have a clear statement of risk appetite that cascades down from the top of the firm to individual business lines. Senior management will therefore need to ensure they have appropriate analysis to allow them to understand the risks they are accepting before signing off their firm’s climate risk appetite.

In line with this, robust risk management frameworks, based on transparent assumptions with appropriate senior management oversight, will allow firms to balance the risks they face when setting their business strategy.

All of this will depend on the availability of high-quality disclosures. To this end the PRA continues to be a strong supporter of the International Sustainability Standards Board (ISSB) and the development of a framework for UK Sustainability Reporting Standards (SRS). Comprehensive and consistent disclosures should support transparency and the efficient management of climate risk. 

From a regulatory perspective, our approach has not changed. Our supervision is still forward looking, risk-based and proportionate. The expectations have been designed to reflect this.

As set out in the paper, we expect each firms’ approach to scale with the level of risk to which they are exposed. As a first step, firms should carefully assess the potential impact of climate change on their business. Where a firm has determined that it faces a less material impact, it may choose to scale its risk management response accordingly, such as using less sophisticated tools so long as its assumptions remain prudent. If the materiality of the risks which the firm is exposed to increase, then we will expect firms to develop their risk management tools proportionately. This should support competition without compromising the effectiveness of the expectations.

While climate risks, and the threat they pose to the PRA's primary objectives of safety and soundness and policyholder protection continue to increase, we also need to consider the effect our policies have from the perspective of our secondary objectives.

The new expectations are likely to impose short-term costs on firms, though given we are mostly clarifying and consolidating existing expectations we expect these to be limited and particularly for firms which have kept up to date with developments. And we estimate those initial costs will be more than offset by the benefits arising from improved identification and management of an important class of emerging risk, which will persist over the medium to long term. In addition, a financial system that is robust to climate risk will be better positioned to support the wider transition to a net zero economy. Our detailed cost benefit analysis is set out in our Consultation Paper, and we welcome views on this and all other aspects of the proposals.

The updated expectations were informed by considerable feedback from firms over the last six years. We want to make sure that we work as closely as possible with firms to help deliver a smooth implementation over the years ahead.

Here we see an important role for the CFRF.

The CFRF was convened by the PRA and FCA in 2019. It was no accident that this coincided with the release of Supervisory Statement 3/19. As the first movers on climate expectations, we recognised firms were being asked to build novel capabilities, some with steep learning curves. Bringing firms in line with the new expectations would therefore require considerable support, ideally through an industry body that could pool expertise.

It was for this reason that the CFRF was established as a group led by, and made up of, representatives from across the financial services industry to build capacity and share best practice across the sector. Over the intervening years it has demonstrated its ability to help guide the financial sector as it adapted to those expectations, as well as to shifts in the risk landscape driven by climate change. I am hugely grateful for its work and the support that has been given by its members.

As a result, firms are not in the same position as they were in 2019. Considerable progress has been made in embedding supervisory expectations and, through that, banks and insurers are more resilient to climate change. The CFRF has played an important part in that progress. However, there are still challenges – which is why we have published our updated expectations today for consultation. Meeting them will require further collective work with industry and academia, facilitated by fora like the CFRF. Together we can ensure that firms are prepared to manage the risks arising from climate change and support the real economy through this major structural shift.

Thank you.

I would like to thank Sarah Breeden, Amy Jane Burrell, Simon Hall, Noelita Ilardia, Nik Prassas, Timothy Rawlings, Roopa Sharma, David Wilkinson and Sam Woods for their assistance in preparing these remarks.