Embedding the financial risks of climate change: Developments and considerations

With the deadline for insurers to embed financial risks from climate change into their risk management framework fast approaching, Milliman consultants in the UK have put together this paper to highlight recent updates and some relevant issues and considerations for firms.

Recent regulatory climate change developments

Climate Biennial Exploratory Scenario (“CBES”)

The latest of the Bank of England’s regular stress test exercises explores the resilience of the largest UK banks and insurers to the physical and transition risks associated with climate change. The Bank of England hopes that the CBES exercise will help it to assess the size of participants’ financial exposure to risks from climate factors, understand the challenges these risks pose to business models and assist participants in developing their management of climate-related risks. The Bank has invited only the largest UK insurers to complete the CBES and therefore the exercise is not directly relevant to most firms. However, other firms may find it useful to read the paper for information purposes. CBES may provide some indication of the direction in which the Bank is heading with respect to climate change scenario analysis requirements. For example, the emphasis on counterparty analysis and on how firms intend to develop their business models over time in response to the financial risks from climate change may indicate that these are likely areas of future focus for the Bank. Please see the section on scenario analysis later in this paper for more information.

FCA-proposed disclosure requirements

In June 2021, the Financial Conduct Authority (FCA) set out proposals to introduce climate-related financial disclosure rules for asset managers, life insurers and FCA-regulated pension providers. The proposals in Consultation Paper 21/17 are consistent with the recommendations by the Task Force on Climate-related Financial Disclosures’ (TCFD) and are aligned to the HM Treasury Roadmap, which will introduce TCFD-aligned disclosure requirements across the UK economy by 2025. The TCFD recommendations cover disclosures in four areas: governance, strategy, risk management and metrics and targets.

The proposals would require entity-level disclosures—an entity-level TCFD report—published in a prominent place on the firm’s website. Whilst this will require some firms to develop an entity-level view of climate-related risks and opportunities faced by their business, firms will still be able to make use of work done at the group level, if relevant to the entity, by cross-referring to disclosures made in a group report (or other relevant report, e.g., as reported by a delegated investment manager or in the entity’s annual financial statements). The proposals also require product-level or portfolio-level disclosures, published annually, covering core metrics on carbon emissions and carbon intensity.

The proposed implementation timeline would require firms with at least £25 billion in assets under management to comply with the rules from 1 January 2022 (with first disclosures to be made by 30 June 2023), and those with assets under management of £5 billion or more to comply from 1 January 2023 (with first disclosures to be made by 30 June 2024). The consultation period for the proposals closed on 10 September 2021, with the FCA aiming to publish a policy statement later in 2021.

Questionnaire on SS3/19 readiness

We understand that many firms recently received a questionnaire from the PRA, with questions covering the current status of their management of the financial risks from climate change. This questionnaire indicates the interest of the Prudential Regulation Authority (PRA) in ensuring that firms are at an advanced stage of preparation in terms of complying with the SS3/19¹ requirements in time for the yearend (see the next section of this paper for further details). Firms may find the subject of the questions in the questionnaire useful when checking that they have covered all the SS3/19 requirements in their preparations.

SS3/19: Embedding the financial risks from climate change

The PRA has set out how all UK insurers and banks should manage climate-related risks in its supervisory statement, SS3/19. By the end of 2021, it expects PRA-regulated firms to be able to demonstrate that the expectations set out in SS3/19 have been implemented and embedded throughout their organisations as fully as possible.² Its expectations cover four key areas:

• Governance
• Risk Management
• Scenario analysis
• Disclosures

Through assisting firms to embed these requirements within their risk management framework we have identified a number of the more complex considerations faced by firms.

Governance

As part of the SS3/19 governance requirements, the board is required to be able to understand and assess the firm’s financial risks from climate change, and particularly be able to oversee the risks within the overall business strategy and assess risk appetite. We have observed in some cases that the board does not always have sufficient information with which to articulate how strategy is impacted by the risks from climate change. This includes the ability to articulate how climate change-related risks may affect the business strategy, as well as to articulate the firm's strategy with respect to climate change. On the latter point, until a firm has a board-approved climate strategy, it is hard to create a coherent and integrated approach which is consistent across the risk management framework, and across the four areas defined in SS3/19.

In articulating their strategies, firms need to consider their ambitions with respect to the management of climate change risk. This may cover areas such as the extent to which they intend to target net zero³ (in respect of the carbon footprint of their operations, their investments, or both), the extent to which they intend to be a force for good in reducing carbon emissions and the extent to which they want to pursue and support climate-related opportunities.

Another challenge in this area is in obtaining engagement from across the business. The Senior Management Function (SMF) responsible for climate change (a requirement of SS3/19 is to appoint a SMF to take responsibility for managing the financial risks of climate change) needs support from across the lines of defence in order to implement a successful and consistent approach to managing the financial risks from climate change. Gaining support from the top echelon of the business can, therefore, be particularly crucial in setting the tone and encouraging engagement from all parties.

In other aspects of governance firms may find there are some more straightforward areas where they can incorporate risks from climate change—for example including climate change-related risks in the terms of reference of the committees.

Risk management

In SS3/19 the PRA outlines a number of requirements with respect to risk identification and management, monitoring, mitigation and reporting. An overarching point is that it “expects firms to address the financial risks from climate change through their existing risk management frameworks, in line with their board-approved risk appetite.” This is a particularly challenging point as it requires firms to consider how climate-related risks integrate with their existing key risk categories, and not as a standalone category with its own risk appetite and tolerance levels. For example, an existing risk policy may articulate a particular tolerance for volatility of equity risk, in terms of the impact on the Solvency Capital Requirement (SCR) coverage ratio. To embed climate change then requires firms to articulate how climate may be a factor within this existing tolerance. I.e., how much equity volatility are you willing to accept as a result of climate-related risk drivers?

Another challenge in this area is data requirements and the associated costs of obtaining this data. The statement that the “PRA expects firms to consider a range of quantitative and qualitative tools and metrics to monitor their exposure to financial risks from climate change” requires firms to access new data to create relevant metrics for tracking and framing targets. For example, firms may want to start producing carbon emission metrics such as those defined in the TCFD disclosure requirements; however, many firms will not currently collect the necessary data.

Scenario analysis

SS3/19 requires firms to develop a proportionate and integrated approach to including climate scenarios as a means of understanding the impact of financial risks from climate change on their business. "Proportionate" may be a bit of a scapegoat word for some first-line functions, as without deep evaluation they may consider their risk areas not impacted at all. In this instance it is the second-line responsibility to help the business understand the second-order effects of climate-related risks that may materialise as a result of physical and transitional impacts. For example, for life insurers changes in climate will likely lengthen the transmission season and geographical range of vector-borne diseases like malaria.

Other areas that are challenging for firms when it comes to articulating and implementing climate scenarios include:

• Translating the science of climate change and qualitative discussions into quantitative scenarios
• The long-term nature of published climate scenarios, such as those within the CBES exercise, compared to the relatively shorter stress test scenarios to which a firm would be accustomed
• How to model gradual and fundamental climate and macroeconomic shifts within existing models compared to shock scenarios that insurers are more familiar with
• The significant degree of uncertainty and influence of potential government policies or taxes, the speed and timing with which they emerge and progress in technology

Our advice to firms would be to get started and accept that climate scenario analysis will be an iterative process, as more data and information becomes available and as models can be adapted to handle some of the complexities. Firms should consider their business models and work backwards to identify the macroeconomic changes and physical damages that could put the business model at risk. These changes can then be linked to a climate driver to develop the scenarios most relevant to the firm.

It may also help to consider financial risks from climate change separately over the near term, to align with own risk and solvency assessment (ORSA) and business planning timelines and long-term horizons for emerging climate-related risks and horizon scanning. The risks in these two timeframes will be different at present and allow for more focused considerations. However, firms should bear in mind that, even if the risk is not expected to materialise for some time, the period for taking meaningful action could be much more proximate.

Disclosures

In the first instance firms need to ensure that they are covering the minimum existing requirements with respect to disclosure. As highlighted in SS3/19, for insurers this corresponds to the Pillar 3 requirements under Solvency II to disclose all material risks to the business. As noted earlier in this paper, should the proposed FCA disclosure requirements be confirmed, entities will also need to start publishing their own TCFD reports if they come within the scope of the requirements. For firms new to this type of reporting, gathering the relevant data to report the TCFD metrics could be one of the key challenges to overcome.

Additionally, firms will need to demonstrate that they have, at a minimum, considered the need for other types of disclosure in order to comply with the requirement to “consider whether further disclosures are necessary to enhance transparency.” This might include an appraisal of the necessity of such disclosures by the risk function, with the decision evidenced through a short report and/or management approval. It will also be key for firms to consider emerging practice in the insurance sector with respect to disclosures, to avoid any reputational issues arising.

Lastly, in order for climate-related disclosures to be useful, they need to be consistent and comparable across the industry, and the current lack of a consistent classification of climate-related terminology makes this a challenge. In order to address this challenge, and to introduce a common framework for defining what is meant by "environmentally sustainable," the UK government has convened the Green Technical Advisory Group to oversee the introduction of a green taxonomy in the UK. In addition, it has announced the planned introduction of economy-wide sustainability disclosure requirements and sustainable investment labels, to streamline existing reporting requirements and to allow the sustainability of investments to be compared. These measures should go some way in addressing the industry-wide need for consistent and comparable disclosures.

¹Bank of England (15 April 2019). Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. Supervisory Statement 3/19. Retrieved 25 October 2021 from https://www.bankofengland.co.uk/prudential-regulation/publication/2019/enhancing-banks-and-insurers-approaches-to-managing-the-financial-risks-from-climate-change-ss

²Bank of England (1 July 2020). Letter from Sam Woods: Managing climate-related financial risk—thematic feedback from the PRA’s review of firms’ SS3/19 plans and clarifications of expectations. Retrieved 25 October 2021 from https://www.bankofengland.co.uk/prudential-regulation/letter/2020/managing-the-financial-risks-from-climate-change

³Net zero refers to a state in which the greenhouse gases going into the atmosphere are balanced by removal out of the atmosphere.