In May 2022, the Bank of England published its first Climate Biennial Exploratory Scenario (CBES), designed to explore how exposed banks and other financial institutions are to climate-related risk. By exploring three distinct scenarios modelled over the next 30 years, the CBES predicts how financial institutions might respond to risks and examines the potential consequences of those decisions for UK households.
This guide is aimed at mortgage lenders wanting to know the key findings of the CBES and the reported implications of climate risk on UK housing. It draws particular attention to the role of data and the need to improve the measurement and modelling of climate risk so that a more nuanced and informed approach to lending, pricing and investing can be adopted.
The first Climate Biennial Exploratory Scenario was launched in May 2020 by the Bank of England. Largely in response to the 2008 financial crisis, the Bank has maintained a remit to monitor and assess how resilient UK financial institutions are to shocks. In March 2013, the Financial Policy Committee (FPC, an official committee of the Bank) recommended that:
‘Looking to 2014 and beyond, the Bank and Prudential Regulation Authority (PRA) should develop proposals for regular stress testing of the UK banking system. The purpose of those tests would be to assess the system’s capital adequacy.’Bank of England, Stress testing the UK banking system: guidance for participating firms (April 2014)
The stress testing framework consists of two methods: to annually stress test the solvency of banks and to undertake biennial exploratory scenarios. The CBES is the first such scenario to focus on the climate and explores the risks posed to the UK financial system by climate change.
A number of institutions took part in the exercise, which ran throughout 2021. In total, 7 banks, 5 life insurers, 6 general insurers and 10 Lloyd’s syndicates were involved.
The results of the exploratory scenario are designed to provide insight at all levels of the financial system, from firms to policymakers and regulators, to aid in making decisions and planning risk management strategies.
Climate-related financial risks take two key forms: transition risks and physical risks. Transition risks are those posed by the economy as we become a greener society overall. These could include a shift in the types of investments made by long-term savings providers away from fossil fuels, or shifts away from energy-intensive materials which are used very widely, such as cement. This type of risk is a relatively new addition to the discussion around climate-related financial risks, the Bank of England notes, and previously the conversation focused more heavily on physical risk.
Physical risks are more straightforward as they are those likely to be posed by the changing climate if policy decisions do not slow the rate of global heating. In the context of the financial system, this is particularly concerning when considering increasingly frequent and expensive insurance claims from floods, wildfires and other climate-related incidents, and a growing reliance on insurers to cover increasingly predictable losses, driving premiums up.
The CBES is the first Biennial Exploratory Scenario that focuses specifically on the challenges of climate change for the financial sector, but it is also significantly larger than other similar studies, with some of the largest banks and insurers in the UK investing time and board resources into taking part. Its results also have a much wider global application and are relevant to all banks, not only those who took part, lending it further significance. Ultimately, its impact might most importantly be that it forced lenders, government, and regulators to work together on credible plans to transition to a net-zero economy.
The CBES gave banks and insurers three potential scenarios based on those developed by the Network for Greening the Financial System and asked them to model the impact each would have on their business, including any losses likely to be incurred. Almost all of the risks they were asked to consider were modelled over a 30-year period to align with the broader policy goal of reaching net zero by 2050, although some were evaluated over a 60-year period.
The three scenarios were broken down into different degrees of action taken against climate change. The first ‘early action’ (EA) scenario and second ‘late action’ (LA) scenario explored both the physical risks and potential transition risks when some measure of climate action was taken. The third, or ‘no additional action’ (NAA) scenario, explored merely the physical risks if no action were to be taken on climate change by global governments. Transition risks in this scenario were not required, as no further transition toward net zero was projected to take place, whereas the EA and LA scenarios focused more heavily on the transition risks as physical risks are deemed to be lower as a result of action against global warming having been taken.
The early action scenario is an ambitious look at a version of events where carbon taxes are raised early in the 30-year period and other policies follow steadily. It projects a ‘temporary headwind’ [ref: Bank of England, section 2.2. Scenarios] to economic growth initially, but as the latter part of the scenario plays out and most of the difficult transition has occurred, productivity benefits emerge and the economic gains are realised.
In the late action scenario, such action is less swift. This scenario shows a decade-long lag before meaningful policy measures are made, projecting a more sudden and disorderly transition period where policy plays ‘catch-up’. This involves more disruption to the economy, led by falls in productivity for emissions-intensive sectors, and includes a short recession and rising unemployment.
The third, ‘deliberately severe’ scenario envisions a world where no further climate change action is taken and represents a worse-than-expected outcome. Lack of transition policies ramps up physical risks, leading to rising greenhouse gases, severe weather events, dramatically altered living conditions, and heightened global inequality. As a result, there is projected global and domestic economic uncertainty and permanently reduced GDP growth.
Each of these scenarios produced some level of persistent drag on profitability for banks and insurers and across the three scenarios, annual average profit reductions of 10-15% were indicated. This alone would make both firms and the financial system more vulnerable to other future shocks.
However, a scenario with early, well-managed measures to transition to a net zero economy limited the financial impact of climate change most effectively, with lower overall costs. In this instance, a significant portion of transition-related costs is passed to customers, meaning the price of transition would not threaten the solvency of banks and insurers significantly. These transition risks would largely come from the cost of improving the energy efficiency of homes – which would fall to consumers – and how this would impact property prices and borrowers’ affordability profiles.
Physical risks are more dependent on which scenario is considered. Climate-related physical risks include flooding, wildfires, storm surges and extreme wind, with the UK most affected by flooding (although to what extent depends on which scenario is realised). This could have an impact in two ways. Firstly, mortgage impairments are more likely in areas where the flood risk is higher and secondly, that policymakers would be required to spend money otherwise earmarked for climate action (such as decarbonisation schemes for households) on damage repairs after flooding.
The results of the CBES make clear where the climate pathways diverge from one another in their outcomes. For example, when early action is taken, mortgage losses are relatively muted compared to the substantial increase in the late action scenario. In both transition scenarios – i.e. where further action against climate-related risks is taken – the assumption is that households will fund making their homes more energy efficient, and this liability will further affect borrower affordability.
The Bank of England estimates the cost to UK mortgage customers to be around £75 billion. The loss rates for banks were focused on realised credit losses only and projected to rise in all three scenarios. As shown in Chart 1 below, bank credit losses will be around £110 billion greater and loss rates more than double as a result of climate risks if late action is pursued over early action.
In homes where the potential energy efficiency ratings are in the lowest two brackets, F and G, the concern around mortgage impairment grow – both in that the cost for retrofitting is prohibitively high, potentially affecting mortgage repayments, and that these properties become unmarketable without such work (see Chart 2). These properties, however, only represent a very small fraction – less than one per cent – of total mortgage portfolios in the UK.
The biggest area of divergence between the scenarios is, unsurprisingly, when considering mortgage losses in the NAA scenario. Losses are higher and concentrated in areas impacted by flooding to the extent that a tenth of all postcodes would account for almost half of all projected mortgage losses.
The banking sector does not yet have a well-established framework for understanding climate risk appetite, or the level of climate risk it is willing to accept to achieve its objectives. Indeed, climate risk currently tends to be adopted into a broader risk appetite framework alongside capital management or performance measurement, which does not allow for climate-related risks to be properly explored.
This lack of framework has been hindered in part by a lack of data. Without the sufficient quality and quantity of data needed to design a way to measure, model and assess climate-related risks, banks and insurers involved in the CBES largely relied on qualitative statements of risk appetite.
Few of the firms involved had reliable quantitative measures or modelling capabilities, and much of the data was incomplete, out of date or unstandardised.
In addition, much of the modelling was done by third parties, lacking clarity as to the assumptions made when considering each scenario. This leaves us with estimations for key aspects of the modelling, such as exposure to certain risks for each business, and leaves room for banks and insurers to implement management strategies that do not accurately address their own position or the scope of climate risks relating to their business and their customers.
One such example is Energy Performance Certificate, or EPC, ratings. Performed by EPC assessors (except in Scotland, where government-approved firms undertake ratings), these provide valuable information about the energy efficiency of homes, including how much energy they use per square metre and what level of carbon dioxide emissions they create. Ratings are given from A to G – with A being the most efficient, and G the least.
Homes in the private rented sector have been required to reach the E rating (or above) since 2018, and from 2025 will be required to meet C or above for new tenancies. Homeowners must provide an EPC rating when selling a property to another residential buyer, but there are no current minimum requirements to meet for the sale to take place.
More crucial than the existing rating, perhaps, is that the EPC also provides a potential rating to indicate how much more energy-efficient a home could be with retrofitted measures such as insulation or improved fittings. While the given rating is based on standard assumptions about energy use and occupants, introducing a margin of error, an EPC rating nevertheless provides home-level data about housing stock in the UK that could be crucial for household lenders looking to consider the impact of climate risk on their customers.
However, without accurate data on how many homes require retrofitting to meet energy efficiency standards (and the associated costs) a lender is unable to calculate what proportion of its borrowers will be likely to fall into mortgage impairment, thus miscalculating its potential losses. The data for EPC ratings was found to be inaccessible or requiring sophisticated modelling in order to properly determine risk over a long time period. As both the late action and no action scenarios come with heightened physical climate risks, such miscalculations could be very costly.
Indeed, lenders could look to obtain more broad Environmental Performance Certification data on their customers’ properties. This not only measures the energy efficiency of a home but also considers the source, recyclability, and toxicity of its building materials: particularly for mortgage firms lending on new build properties, this could drive real industry change and set new standards for the environmental impact of new homes built in the UK, but also provide much-needed data into a bank’s exposure to climate risk.
Lenders need, then, to invest in the expertise and skills to better understand both transition and physical climate risks. To develop business models which include sound pricing and investment decisions, climate risk modelling must encompass a level of nuance, detail and accuracy that helps prevent catastrophic miscalculations.
Lenders should consider both transition and physical risks when improving their climate risk modelling.
Firms should consider engaging with external specialists alongside internal ones. This reduces the risk of incorrect assumptions or bad data, and helps validate their existing business models and results, although third-party models should also be scrutinised to ensure lenders understand the scope (including assumptions made and any elements not captured). A ‘one size fits all’ approach is not appropriate and, instead, bespoke modelling should be used to address specific climate vulnerabilities and gather accurate and relevant data.
In the near term, lenders should turn their focus to filling in data gaps and developing a transition plan. The Bank of England noted that firms who were not participants in the CBES have much to learn from the exercise, particularly regarding good practice around risk management, and firms can bolster their own capabilities in that regard by beginning to develop and understand their transition plan.
The work done by the Bank of England on climate scenarios, and particularly the CBES, is a crucial tool in beginning to arm mortgage lenders and other financial institutions against future shocks as a result of climate change.
While the CBES itself has not provided unexpected new conclusions, its strength lies in engaging firms with the act of modelling future climate impacts. The insights and learnings gained are therefore directly relevant to financial services institutions who wish to further develop their risk management strategies.
The Bank of England has not yet announced a follow-up CBES. Although it is clear that further work must be done to fully understand the potential stress caused by climate-related risks, future stress testing may take a different format. For example, future research may include a larger pool of participants or introduce newer methodologies that provide more accurate findings.
But what is clear thus far is that the findings of the CBES will inform the Prudential Regulatory Authority’s approach to climate risk. The report published on the results of the CBES highlighted gaps in both data and approach across banking and insurance. The PRA’s response to these gaps and its future approach will set climate modelling standards that have significant future consequences for the industry.
Kamma works with leaders throughout the mortgage value chain, providing unique data that slashes completion times, minimises risk and simplifies regulatory compliance. Having already delivered 36mn environmental profiles of UK homes, our extensive datasets and analytical capabilities are poised to provide a comprehensive assessment of the energy performance and climate risk of lender back books.
Our technology delivers match and accuracy rates above the industry average, meaning that we can accurately qualify around an additional 20% of a lender’s back book for RMBS and identify risks across a lenders whole portfolio. Similarly, as climate disclosures and risk reporting becomes increasingly important for lenders, Kamma’s approach offers deeper insight on the risks and market opportunities linked to climate change.
In summary, Kamma’s analysis is designed to solve the following business challenges:
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