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This report sets out the Bank’s latest thinking on climate-related risks and regulatory capital frameworks. The report includes updates on: capability and regime gaps; capitalisation timelines; and areas for future research and analysis.
In October 2021, the Bank of England (the Bank) published its Climate Change Adaptation Report (CCAR), which set out early thinking on climate change and the regulatory capital frameworks for banks and insurers. The CCAR set out that the current frameworks already capture climate-related risks (climate risks) to some extent, including through capital models and credit ratings. However, risk capture may be incomplete due to difficulties in estimating climate risks (capability gaps) and there may be challenges in capturing risks in the existing capital regimes (regime gaps).
The Bank committed to undertaking further work on these topics. It has engaged with a range of stakeholders to inform this work, including through a call for research papers and hosting a high-profile, focused research conference, as well as undertaking its own internal work. This report sets out an update and key findings from that work. It does not set out any policy changes but sets out the Bank’s thinking and identifies areas for future work.
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Key findings
- Existing capability and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses. This uncertainty represents a risk appetite challenge for micro and macroprudential regulators. Regulators, including the Bank, need to form judgements on whether quantified and unquantified risks are within risk appetite – and act accordingly.
- Effective risk-management controls within PRA-regulated firms (firms) can reduce the quantum of capital required in the future for resilience, but the absence of controls might suggest a greater quantum of capital will be required. As a short-term priority, the Bank is focused on ensuring firms make progress to address ‘capability gaps’ to improve their identification, measurement, and management of climate risks.
- The Bank has explored conceptual issues to better understand the nature and materiality of ‘regime gaps’ in the capital framework. The unique characteristics of climate risks mean that their capture by capital frameworks requires a more forward-looking approach than used for many other risks. Scenario analysis and stress testing will play a key role in this. Regulators, including the Bank, need to focus on the development of these frameworks and how they can inform capital requirements. Firms will be expected to make further progress in this regard.
- Current evidence suggests that the existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks. Therefore, there does not appear to be sufficient justification for regulators, including the Bank, to make a policy change to these time horizons. The Bank will continue to explore how climate risks can be calibrated within the timelines embedded in existing capital frameworks.
- Further work is needed to assess whether there may be a regime gap in the macroprudential framework. Any use of macroprudential tools would need to be assessed carefully against how well they mitigate climate risks, their behavioural impacts, and the potential for unintended consequences. Calibration of macroprudential tools would also be challenging given uncertainties around climate risks and the need for them to help facilitate an orderly transition to net zero. The Bank will explore the nature and materiality of such regime gaps as part of its ongoing policy work and consider whether action to address them would be appropriate.
- Research on the conceptual challenges of incorporating climate risks into the capital frameworks appears to be limited based on submissions to the Bank’s call for research papers. Further research and greater public dialogue would therefore be valuable, notably in sparsely covered areas listed within this report. More detailed research/analytical questions and how to notify the Bank on future relevant projects is set out in the Annex.
3. The Bank will undertake further analysis to explore whether changes to the regulatory capital frameworks may be required. In particular, the Bank will progress work to:
- ensure firms continue to make progress to address capability gaps;
- build its capabilities and forward-looking tools to judge the resilience of financial system to climate risks;
- support initiatives to enhance climate disclosures;
- promote high quality and consistent accounting for climate risks;
- build understanding of and address material regime gaps in the capital frameworks;
- supervise against SS3/19 – ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change’, including work to build an understanding of banks’ evolving approaches to Pillar 2 add-ons; and
- engage in relevant discussions at international fora to inform domestic policymaking.