The 2021 biennial exploratory scenario on the financial risks from climate change: submission to the Bank of England
This is a response to the discussion paper The 2021 biennial exploratory scenario on the financial risks from climate change (PDF), which was published by the Bank of England in December 2019. This response has been prepared by authors from the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science, the Grantham Institute – Climate Change and the Environment at Imperial College London, and the University of Edinburgh Business School. The authors have responded to the questions within their remit of expertise only. The response was submitted to the Bank of England on 18 March 2020.
- The 2021 biennial exploratory scenario (BES) exercise represents an important step forward for the Bank of England’s response to climate change. Its results will not only enable an understanding of the positioning of different firms in the face of the risks posed by climate change, but it will also contribute to knowledge of the overall resilience and stability of the UK financial system over the coming decades. The 30-year horizon for the BES is a welcome innovation and aligns the exercise with the UK’s legal commitment to reach net-zero annual emissions of greenhouse gases by 2050.
- The BES exercise could be strengthened by more clearly anchoring its design to the Paris Agreement and the conclusions of the Intergovernmental Panel on Climate Change (IPCC), notably its recent special report on Global Warming of 1.5˚C (IPCC, 2018). Specifically, the scenarios need to be rooted in the goal of the Paris Agreement of “holding the increase in the global average temperature to well below 2˚C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5˚C above pre-industrial levels”.
- It should be noted that the BES exercise is not strictly a stress test because the scenarios are based on central assumptions and do not include the lower probability and higher impact consequences. The exercise could be further strengthened by moving away from the central case approach of physical and transition risks. A stress test that does not assess resilience to tail risks could be counterproductive by hiding potential exposures and vulnerabilities. The BES exercise should include higher impact and lower-probability physical and transition risks. This would mean including thresholds and non-linearities and capturing climate, social and policy changes lying outside the central estimates of the probability distributions.
- Assessing a firm’s resilience under different future scenarios is complicated by deep uncertainties around climate change impacts, socioeconomic pathways and technological progress, as well as by the fundamental limitations of currently available modelling techniques (see e.g. Chenet et al., 2019; Stern, 2016). It is important that the Bank of England recognises those uncertainties and includes sensitivity analyses of the underlying assumptions and parameters in the BES exercise. Given the inherent limitations of different models, much of the work will need to be carried out by complementing the exercise with supplementary tools and expert judgements, as well as by qualitative understanding of the results. This would highlight the value of the exercise as an organisational learning exercise rather than as a tool that generates conclusive results.
- The requirement for participants to submit the ‘temperature alignment’ of their balance sheets and portfolios is a major and welcome innovation. This will help firms, consumers of financial products, regulators and policymakers to develop a better understanding of how large financial institutions are positioned in terms of transition pathways. The Bank should consider publishing an overall temperature alignment score for the entire UK financial system, separating where possible the score for UK-related assets and assets held by UK firms that are held overseas. The Bank should also explore how regulated firms in the banking, insurance and other sectors can make the reporting of their temperature alignment scores a routine and expected part of their annual disclosures, for example in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). In addition, the Bank should work with other regulators, notably the Pensions Regulator and the Financial Conduct Authority, to make sure that this crucial information is made easily available to beneficiaries and savers, for example, as a requirement in regular statements on pensions and Individual Savings Accounts (ISAs).
- The results of the BES exercise could also provide profound insights into how climate change could impact the UK’s financial resilience at a regional level. For example, geographical concentrations of risk, arising from either the net-zero transition or the physical impacts of climate change, could be identified for specific parts of the country. This would assist planning by both financial firms on their commercial response to the risks, and by policymakers to ensure that the transition does not have the unintended impact of leaving some communities behind. The Bank of England’s network of offices across the country could be usefully deployed to communicate the regional results of the BES exercise to key stakeholders in business, finance, local government and civil society (including trade unions).