Financial regulators focus on climate change risk

Out-Law Analysis | 21 May 2019 | 1:34 pm | 4 min. read

In early May the UK government became the first in the world to declare an environment and climate change emergency. The impact of climate change will affect every aspect of daily life, and generates a number of significant financial risks.

So far, UK regulators have identified three key areas of financial risk associated with climate change.

Firstly, there are physical risks from more frequent and severe floods, fires and droughts with further damage likely from longer-term changes such as soaring temperatures and rising sea levels. Insurers may incur large financial losses due to higher, and more frequent, claims on the policies that they underwrite. This will have a consequential effect for customers with higher premiums for comparable cover offered in previous years.

... there are transition risks associated with society's adjustment to a low-carbon economy

Insurance may even become less available for certain risks. Banks and investors may suffer if property damage affects the value of their investments, particularly if the losses are uninsured.

Secondly, there are transition risks associated with society's adjustment to a low-carbon economy. Expected changes in climate policy or technology will likely prompt a reassessment of the value of assets based upon, or linked to, fossil fuels. Market sentiment will continue to change as new ecological opportunities are realised.

The Bank of England’s Prudential Risk Authority (PRA) has highlighted the increasing importance of 'green finance', which will facilitate additional investment in renewables and energy efficiency.

Disruptive technology and political decision-making are not always foreseeable and can significantly affect investment valuations so banks, investors and insurers will have to ensure that their portfolios are aligned with climate targets and are sufficiently resilient to withstand rapid system-wide adjustments.

... companies will be increasingly scrutinised for climate-sensitive choices

Finally, liability risks arise from parties who have suffered loss or damage from the physical and transition risk factors and who seek to recover those losses from those they hold responsible.

These risks mean that companies will be increasingly scrutinised for climate-sensitive choices and expected, for example, to: protect stakeholders from devaluations to their investment caused by physical and transition risk; and to accurately report on their potential exposure to climate-related financial risk to potential and actual investors, as failure to do so could result in legal action for misrepresentation.

Companies, particularly operating in the fossil fuel sector, could face litigation if their actions are considered to have contributed directly to losses related to climate change. Recent calls have been made to make those who contribute to serious damage to, or destruction of, the natural world and its systems, liable to criminal prosecution. These risks are particularly relevant for insurers that underwrite professional indemnity and directors and officers’ insurance.

Expectations for firms

In April the PRA published a supervisory statement (11 page / 880KB PDF) on ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate' as well as an accompanying policy statement (12 page / 889KB PDF).

The PRA's desired outcome is that firms "take a strategic approach to managing the financial risks from climate change, taking into account current risks, those that can plausibly arise in the future, and identifying the actions required today to mitigate current and future financial risks".

Firms are required to have initial plans and updated senior management function (SMF) forms in place by 15 October 2019. The expectations for firms’ behaviour cover a number of areas, but responses must be "proportionate to the nature, scale and complexity" of their business.

Climate-related financial risks will need to be identified, measured, monitored, managed and reported on

Firms will be expected to fully embed the consideration of climate-related financial risk into their governance framework. This will include ensuring sufficient board-level engagement and accountability over how climate change affects business strategy and risk appetite; creating sub-committees to manage climate-related financial risk; and assigning individual responsibility to SMF holders.

Financial risks will be expected to be addressed through firms' existing risk management framework and risk appetite. Climate-related financial risks will need to be identified, measured, monitored, managed and reported on.

Firms will be expected to use scenario analysis testing to assess the impact of the transition to a lower-carbon economy on their current business strategies to include short and longer term assessments. They will also be expected to develop and maintain an appropriate approach to disclosing how climate-related financial risks may impact upon their business.

During the consultation process financial institutions raised a number of queries about how effective changes should be implemented. Some suggested it could be too early to assign individual accountability under the Senior Managers Regime, as most SMFs do not yet have the relevant technical expertise.

Firms wanted further guidance on how risk management expectations should be incorporated within the Internal Capital Adequacy Assessment Process or Own Risk and Solvency Assessment (ORSA), as well as on how to stress test long-term risks and the metrics and targets which they should use when making disclosures.

Regulators’ response

The PRA said it would develop more granular requirements in time to address many of the queries raised during the consultation process, and acknowledged that, as firms are still building the internal expertise necessary to manage climate-related risks, they will need time to be able to meet all of its expectations. Supervision of firms' management of climate-related risks will, however, intensify over time.

The Financial Conduct Authority (FCA) also published a discussion paper on climate change and green finance in October 2018. The FCA and PRA have indicated their intention to implement a joined-up approach and to share best practice, and recently were jointly involved in the establishment of the Climate Financial Risk Forum (CFRF).

... while UK insurers, banks and other financial institutions will justifiably be concerned about the emerging risk landscape presented by climate change, it is worthwhile considering the huge opportunities for positive change 

The CFRF was established to enable the UK financial services sector to build intellectual capacity and share best practices in managing the financial risks brought about by climate change, and comprises a range of stakeholders including banks, insurers and asset managers.

In its first meeting in April, the forum set up four working groups to focus on areas broadly correlating with those covered in the PRA's supervisory statement: risk management; scenario analysis; disclosure and innovation.

The working groups will meet more frequently than the CFRF itself (which meets three times a year) and will report back with practical guidance which will eventually be shared by the CFRF with the industry more widely.

The hope is that the working groups will help develop a response to the financial risks of climate change which will drive innovation. The Organisation for Economic Development and Cooperation states that an estimated $90 trillion will be required to finance the move to a low-carbon, green economy.

This means that, while UK insurers, banks and other financial institutions will justifiably be concerned about the emerging risk landscape presented by climate change, it is worthwhile considering the huge opportunities for positive change available to those willing to embrace the challenge.

Elaine Quinn and Edward Lister are insurance law experts at Pinsent Masons.