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Prudential Regulation Update – Changes to Capital Framework for Stress Tests
Managing the Financial Risk of Climate Change
24 May 2019
In April 2019 the Prudential Regulation Authority (PRA) published its Policy and Supervisory Statement on managing the financial risk of climate change. In this latest blog, Carl dissects these immediate expectations which requires firms to adapt governance, risk management framework, stress testing and more - ahead of the formal submission deadline, 15th October 2019.
The financial risks associated with climate change can be broadly classified as physical and transitional;
- Physical risks relate to specific events (such as extreme weather or flooding) or changes in climate (Rising sea levels and average temperatures)
- Transitional risks relate to adjustments towards a low-carbon economy such as changes to law, policy or regulation
Managing the risk from climate change presents a unique challenge when the possible impacts are considered. The scope and scale are great and could cover multiple industries across many countries. The time horizon for impacts are uncertain, but may be measured in decades rather than years, falling beyond current financial planning horizons. While quantifying the precise impacts and timings may be difficult, there is strong likelihood that in the future, financial risks stemming from climate change will occur.
The magnitude of these impacts will be influenced by actions taken today by both firms and governments. An orderly transition to a low-carbon economy provides the strongest basis for mitigating potential risk, but the longer this takes, the greater the impact will be.
Governance and Senior Manager Accountability
Key to ensuring commitment to managing the risks posed by climate change is making senior management directly responsible for the firm’s strategy. The PRA require the board of each firm to identify the most appropriate Senior Management Function (SMF) and delegate the necessary responsibilities. This should be detailed in the role’s Statement of Responsibilities.
Some concession is offered given the challenges in immediately achieving this requirement. The PRA are not planning to make climate risk management a prescribed responsibility. The PRA also recognise that firms are only starting to build the relevant expertise in managing this risk. As such, the responsible individuals should initially be accountable for defining and delivering a plan to meet the requirements in the policy and statement, but not for its overall delivery. The individual identified should be formally submitted to the PRA by 15 October 2019. By this point a plan is also expected to be in place.
The PRA are not specific as to whether firms: must link climate management expectations to remuneration; require specific skills or experts on the board; create a specific climate change function; set a specific frequency of board assessment. However, they reiterate that they expect firms to show that senior manager pay is influenced by the delivery of major supervisory priorities.
The PRA are also not specific as to the requirement for first and second line responsibilities. It is up to the firm to decide and demonstrate it is managing the risk appropriately within its risk management framework.
The PRA expects the financial risk of climate change to be managed through the firm’s risk management framework within the firm’s board-approved risk appetite, as comprehensively as other major risks. Strategic management must be apparent and evidenced through policy, control standard, management information and reporting to a firm’s board with appropriate frequency and detail for the size of risk that climate change poses.
The Policy and Supervisory Statement do not set specific expectations for a firms ICAAP outside of identifying and assessing the impact of material exposures relating to the financial risk of climate change. However, the PRA expects firms to work with them to develop an appropriate approach, with guidance being developed as best practice becomes apparent.
Monitoring of the exposure to the risk should be performed using quantitative and qualitative approaches. The same metrics should also be used to report the progress against strategy and risk appetite.
There is a proportional requirement to perform scenario analysis to determine financial impacts with respects to solvency and liquidity over-time on a firm’s risk profile and strategy. Both a short-term assessment that quantifies exposure to financial risks of climate change within the existing planning horizon, and long-term scenario analysis to assess how climate change may impact a firm’s business model over a period of decades are necessary. The PRA identify the ICAAP stress testing process as the ideal place for this activity.
The PRA are also including climate change impacts in the 2019 insurance stress testing and the Bank of England will consider including the impact in future Biannual Exploratory Scenarios (BES).
The PRA requires that firms develop and maintain an appropriate approach to disclosure of climate-related financial risks, taking into account not only the interaction with existing categories of risk, but also the distinctive elements of the financial risks arising from climate change.
The PRA recommends following disclosure initiatives set by the Task Force for Climate-related Financial Disclosures (TCFD)
Conclusions and Key Challenges
The requirement to incorporate climate change into a firm’s risk management framework presents several key challenges;
Skills and Experience – The PRA expects that firms may currently lack the skills and experience to effectively identify and manage the financial risk of climate change. This experience at all levels will need to be increased and the path to develop the skills outlined in a feasible plan. As best practice is yet to emerge, the competition for staff with suitable skills and experience is likely to be high.
Lack of Suitable Data – Firms are unlikely to hold data that is suitable to model the impacts of such an emerging risk. Previous events are unlikely to represent the magnitude and scale of future events. It is also likely that data gathered from clients and counter-parties during underwriting is insufficient. The PRA sets the expectation that firms should work with their customers to gather data and identify risk factors, as well as working with external data sets and experts.
Identifying vulnerable assets and understanding potential impacts – The scope and time horizon challenges that climate change poses also make it difficult to identify specifically which assets are likely to be impacted. With a lack of established best practice, firms will need to research and analyse their balance sheets to draw conclusions as to the assets that may be impacted and what events they are vulnerable to.
Identifying how climate change interacts with other key risk – Once vulnerable assets can be identified, there is also the interactions with other key risks to consider. Climate change will interact with and impact Credit, Operational and Market risks
Scenario testing – Constructing a scenario where climate change has an impact is a challenge. Quantifying the macro economic impact of the transitional risks will become a key feature in future concurrent stress tests, but firms will need to tailor a scenario that challenges its balance sheet for the purposes of strategic planning, ICAAP and IFRS 9 modelling. The time horizon is particularly challenging, requiring very long-term forecasts.
For support preparing for the October 2019 deadline, get in touch with our risk experts.