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Ben O'Brien, Managing Director

The author

Ben O'Brien

Managing Director

 

Beyond politics and pandemics, climate change has a key part to play in the future story of humanity. It is possibly the most important challenge to modern life. Not least because we seem better suited to tackle the immediacy of present challenges, such as Covid-19, rather than the real danger that climate change represents for future generations.

Through Climate Biennial Exploratory Scenarios, an opportunity has been afforded to financial firms to act now. Keep reading to delve deeper into this opportunity.

Overview of the Climate Biennial Exploratory Scenario (CBES)

CBES assesses the resilience of the UK’s largest banks and insurers to physical and transition climate-related risks with the following aims:

  1.  Measure the size of the financial exposures of participants, and the financial system more broadly, to climate-related risks.
  2. Understand the challenges to participants’ business models from these risks and gauge their likely responses and the implications for the provision of financial services.
  3. Assist participants in enhancing their management of climate-related financial risks. This includes engaging counterparties to understand their vulnerability to climate change.

The CBES uses three scenarios to explore the two key risks from climate change:

  1. Transition risks that arise as the economy moves from a carbon-intensive one to net-zero emissions.
  2. Physical risks associated with higher global temperatures likely to result from taking no further policy action.

All three scenarios explore both transition and physical risks to a different degree.

The Three Scenarios

The Bank of England clearly states that CBES are not forecasts of future outcomes but plausible predictions of what might happen based on different paths of government climate policies. Each scenario is assumed to take place over the period 2021–50. The exercise considers two routes to net-zero greenhouse gas emissions, an Early and Late Action scenario. These scenarios primarily explore transition risks from climate change.

1. Early Action

The transition to a net-zero economy starts in 2021, so carbon taxes and other policies intensify gradually over the scenario horizon. Global carbon dioxide emissions are reduced to net-zero by approximately 2050. Global warming is limited to 1.8°C by the end of the scenario (2050), relative to pre-industrial levels. Some sectors are more adversely affected by the transition than others. However, the overall impact on GDP growth is muted, particularly in the latter half of the scenario once a significant portion of the required transition has occurred and the productivity benefits of green technology investments begin to be realised.

2. Late Action

The implementation of policy to drive the transition is delayed until 2031 and is then more sudden and disorderly. Global warming is limited to 1.8°C by the end of the scenario (2050), relative to pre-industrial levels. The more compressed nature of the reduction in emissions results in material short-term macroeconomic disruption. This affects the whole economy but is particularly concentrated in carbon-intensive sectors. Output contracts sharply in the UK and international economies. The rapid sectoral adjustment associated with the sharp fall in GDP reduces employment and leads to some businesses and households not being able to make full use of their assets, with knock-on consequences for demand and spending. Risk premia rise across multiple financial markets.

3. No Additional Action

This third scenario explores the physical risks from climate change. There are no new climate policies introduced beyond those already implemented and the absence of transition policies leads to global temperature levels reaching 3.3°C higher, relative to pre-industrial levels by the end of the scenario.

On February 11th 2022, the second phase of the BES was published. This stress test will be shared by the largest banking and insurance organisations and should lay out a framework for understanding climate risks and how to accurately reflect such risks in the pricing of financial services.

The second round of the BES will comprise a small number of questions aiming to further explore participants’ strategic responses to the previously published three scenarios, and the associated implications for their business models. Participants will not be required to update the quantitative loss projections they provided as part of the first round of the exercise. The deadline for participants’ second round submissions will be the 31 March 2022.

The Bank intends for the CBES to be a learning exercise. Expertise in modelling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the Bank and CBES participants. The Bank of England expects to publish results from the Climate BES in May 2022.

If you’d like to speak to Jaywing’s experts about Climate Change Risk and how it could affect your organisation, contact us here.