Bank of England explores impact of climate change on the UK banking sector

With climate change an increasing political and policy concern, the Bank of England (BoE) is making moves to ensure UK banks and insurers measure and understand their exposure to the risks from climate change and adjust their business models and strategies in response. On 8 June 2021, the BoE published “Climate Biennial Exploratory Scenario: Financial risks from Climate Change” (CBES), identifying climate change as a financial risk with a view to exploring its impact on the banking and insurance sectors. It is the first time an exploratory climate-related stress test of UK banks and insurers has been undertaken.

The Regulatory Agenda

In 2021, banks face a number of regulatory and supervisory deadlines. The UK Prudential Regulatory Authority has set a 2021 deadline for UK banks (and insurers) to have strategies and business models to manage climate risks. The European Central Bank will require banks at the Banking Union to undertake a self-assessment of their compliance with its guidance on climate risks in 2021 before conducting a review in 2022. In the US, the New York State Department of Financial Services has set out climate-related standards for banks under its supervision. Rating agencies are also factoring in climate change to their assessments.

In this post we will provide an overview of the CBES and its implications for banks and borrowers.

CBES

The CBES participants are made up of the largest UK banking groups, building societies and insurers. Participants have until October 2021 to make initial submissions, with the results expected to be published in May 2022. The results will be published on a combined basis to reflect systemic risk.

The CBES is intended to be a learning exercise for both the BoE and participants in measuring climate risks based on different policy pathways that could be taken by the government to achieve its aim of net zero greenhouse gas emissions by 2050. The CBES states the exercise will not be used to set capital requirements, however it may inform future policy.

The three stated aims of the CBES are:

  1. measure the financial exposures of participants to climate-related risks;
  2. understand the challenges to participants’ business models from climate-related risks and the implications; and
  3. assist participants in improving management of climate-related risks.

The CBES asks participants to look at three climate scenarios – early policy action (with transition beginning in 2021), late policy action (where transition begins in 2031) and no additional policy action. Each scenario has different outcomes in terms of global temperatures and the economy over the period 2021-2050, a significantly longer time period than the traditional planning period for financial institutions. Participants will measure the impact of the three different scenarios on their year-end 2020 balance sheets.

Within each scenario, two key risks from climate change are identified. “Transition risks” are risks that arise as the economy moves to net zero emissions, such as carbon taxes and changes in technology, regulation and policy that could create credit exposures for banks and other lenders. UK financial institutions are exposed to a wide range of sectors worldwide, many of which will be affected by climate change and the transition to net zero. In addition, reputational risk could arise from shifting attitudes of customers and other stakeholders towards the UK banks response to climate change.

“Physical risks” are the risks that are likely to occur as a result of climate change if no further policy action is taken by the government, such as extreme weather events and rising sea levels. Physical risks could result in large financial losses, reducing asset values and the value of investments held by banks. Extreme weather events are likely to impact businesses, affecting their ability to repay loans and damaging the value of assets.

Opportunities

There are a range of opportunities that banks, borrowers and other lenders are considering, particularly in the green finance space that we have previously covered in posts here and here. It is likely that banks and borrowers will take advantage of the opportunities which arise in the transition to a greener and more sustainable economy, as illustrated by the inflows to green investment products and the growth in the green and sustainability-linked bond and loan markets. With banks looking at how their business models will be impacted by various climate change policies, borrowers will also need to consider how their business practices may need to change in light of the changes to the financing options that might be available.

If you have any questions about this post, please contact Drew D. Salvest, Natalie A. Stewart, Rebecca Green any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you in regular contact.

Duane Morris has an active ESG and Sustainability Team to help organizations and individuals plan, respond to, and execute on Sustainability and ESG planning and initiatives within their own space. We would be happy to discussion your proposed project with you. For more information, please contact Brad A. Molotsky, David Amerikaner, Nanette Heide, Darrick Mix, Vijay Bange, Steve Nichol, or the attorney in the firm with whom you are regularly in contact.

The Network for Greening the Financing System (NGFS) – 90 Worldwide Central Banks and Growing – The Advent of Pricing Carbon into Lending Rates

According to a recent Wall Street Journal Article by Simon Clark, this past December saw the US Federal Reserve join various international central banks and supervisors in the “Network for Greening the Financing System” (the “NGFS”), an international assembly of central banks who set monetary policy around the globe. The NGFS includes central banks and regulators of major European countries as well as Japan, China and Russia. Started in 2007 with 8 members, the NGFS now has over 90 central banks and regulators in its membership and is planning to meet later this month (June) to discuss further policy changes in the climate and risk arena.

Central banks throughout the world are quietly, but more publicly, getting much more involved in climate change risk analysis when setting monetary policy. Some of the central banks are even taking on what some would consider activist stances on the environment and risk. Formerly behind the scenes discussions are evolving into various central banks stating publicly that climate change is a current fiscal and economic risk and, that it is time to take into account these risks when setting monetary policy.

This pivot is already finding its way into monetary policy that will impact US companies doing business overseas, as banks like the Bank of England, now specifically include environmental sustainability as well as price stability in their monetary policy. This policy change will result in US based companies doing business in the UK being impacted by these types of policy changes as it will affect their borrowing rates overseas. For instance, earlier this year the UK Treasury chief changed the Bank of England’s interest rate setting for its committee, to require inclusion of strong sustainable and balanced growth that is also environmentally sustainable as part of its pricing review.

In addition to the Bank of England, the European Central Bank which overseas monetary policy in the EU, has also publicly stated that climate change is within their purview and they will begin taking climate change into consideration when setting monetary rates.

As noted in the Wall Street Journal article, the Bank of France has also begun collecting data on the potential costs of climate change, having found that the cost of insurance claims due to flood and drought impacts are likely to rise by as much as 6x in various French provinces by 2050.

Some of the central banks that are members of the NGFS have adjusted policy based on climate considerations, including higher capital charges for lending to fossil-fuel based companies and including stress testing for climate risk and rising temperatures in their portfolio analysis.

The NGFS’ beginning of increasing of interest rates to address climate concerns, comes at a time where the inflow of investor capital into consumer products, green bonds and stocks of companies focusing more on ESG and products that support ESG and sustainability efforts is at an all-time high and exponentially continuing to show signs of a stable base of investors looking for climate considered attributes.

According to Mr. Simon, the risks being explored include loss of loans or a decline in asset value given locations at or near waterfronts as well as risk adjusting properties in areas that are and have been the subject of wild fire risks. The central banks are also considering charging higher interest rates to lenders that pledge carbon intensive assets as collateral. Meaning, those member banks who continue to lend to carbon intensive asset classes will see higher interest rates that they will pass along to their more carbon intensive customers seeking to borrow these funds

Some of the central banks are also considering whether to require their member banks to set aside additional capital for loans to fossil-fuel companies and less to those in renewable arenas. This would likely translate into loans being made to more carbon intensive user/borrowers having to have a higher loan to value for their assets than their less carbon intensive competitors; resulting in more lending capacity for less carbon use intensive borrowers than their carbon consuming rivals.

Historically, the central banks have always avoided, at least publicly, attempting to influence lending decisions of their member banks where the decisions would have political implications regarding whether climate change is a man-made event. This shift at the NGFS in taking a more public stance, would effectively shift direction for their central bank members and put them directly into the cross hairs of the political discussion of how and what to do about climate change and whether climate change is “man-made”.

Triple Bottom Line – as the NFSG continues to garner more members and, as these members, including the US Fed, start to really include carbon intensity in their pricing decisions for lending, companies that borrow funds internationally will begin to see the impact of their carbon use and will likely face increased risk and higher borrowing costs depending upon how intensive their impact is on the environment. Thus, one’s carbon footprint will actually begin to have a fiscal impact to their operations which will likely create additional disclosure around this risk and attendant result.

Duane Morris has an active ESG and Sustainability Team to help organizations and individuals plan, respond to, and execute on Sustainability and ESG planning and initiatives within their own space. We would be happy to discussion your proposed project with you. For more information, or if you have any questions about this post, please contact Brad A. Molotsky, David Amerikaner, Nanette Heide, Darrick Mix, Vijay Bange, Stephen Nichol, or the attorney in the firm with whom you are regularly in contact.