The Bank of England has launched its Biennial Exploratory Scenario to better understand the resilience of the UK financial system to the physical and transition risks associated with different climate pathways. The intent of this stress test is three-fold:

1. Size 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 2021 BES is the first stress testing exercise to include both banks and insurers in the scope. For banks, the CBES focuses on the credit risk associated with the banking book, with an emphasis on detailed analysis of risks to large corporate counterparties. A key metric of that risk will be the cumulative total of provisions against credit-impaired loans at various points in the scenarios. For insurers, the CBES will focus on changes in Invested Assets (and Reinsurance Recoverables), and Insurance Liabilities (including accepted Reinsurance) assuming an instantaneous shock.

The following is the list of institutions included in the scope of the exercise:

What are the institutions going to assess and under which scenarios?

The CBES exercise will use three scenarios to explore the two key risks from climate change:

• Transition Risks: The risks that arise as the economy moves from a carbon-intensive one to net-zero emissions
• Physical Risks associated with the 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 and each scenario is assumed to take place over the period 2021-50. The scenario specification builds upon a subset of the Network for Greening the Financial System (NGFS) climate scenarios.

Why should institutions care?

The world is moving towards a low carbon future and momentum is building to realize COP26 goals. Developed countries must deliver on their promise to raise at least $100bn in climate finance per year to achieve these goals. Policymakers expect international financial institutions to play their part and work towards unleashing the investments in private and public sector finance required to secure global net-zero by the mid-century. This will inevitably present opportunities as well as downside risks to financial institutions. The latter is of particular concern to regulators.

Expertise in modeling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the regulator and CBES participants. Institutions will be keen to highlight the resilience of their business models, their understanding of the risk exposures, and modeling capabilities in the best light to the regulator. The regulator also has an incentive to demonstrate similarly to the market in an aggregated report. The findings of the exercise will identify areas for institutions to focus on going forward, such as additional data collection, macroeconomic scenario expansion, capacity building for modeling linkages, risk calculation, and reporting.

As this is not a heavy number crunching exercise, and expert analysis will be critical to accurately assess the specific impact of various climate pathways on bank borrowers, investments as well as insurance liabilities. Therefore, institutions may need to expand the variables in the required three scenarios in a consistent and coherent way. Specifically, banks may also need assistance translating the scenarios into credit risk parameters and cumulative total provisions, the key metric that will be explored in the exercise.

We work with many of our financial clients, using our Global Link Model (GLM), to generate forecasts incorporating their views in a manner consistent with the regulatory assumptions provided, such as those by the Bank of England for this exercise. These institutions also use GLM to expand the macroeconomic and financial variables to which their portfolios are sensitive. As such, we will continue to work with them throughout this process monitoring the feedback and insights when the aggregated results are published.

Posted 29 June 2021 by Metin Epozdemir, Head of Global Regulatory Stress Testing and Scenario Analysis, S&P Global Market Intelligence