BoE Proposes Stress Testing Exercise for Climate Change Risks
BoE published a discussion paper that sets out the proposed framework for the 2021 Biennial Exploratory Scenario, or BES, exercise. The exercise will test the resilience of business models of the largest banks, insurers, and the financial system to climate-related risks and, therefore, the scale of adjustment that will need to be undertaken in coming decades for the system to remain resilient. BoE is consulting on the design of the exercise and welcomes feedback on the feasibility and the robustness of these proposals from firms, their counterparties, climate scientists, economists, and other industry experts by March 18, 2020. The final framework will be published in the second half of 2020 while the results of the exercise will be published in 2021.
The exercise will use exploratory scenarios to size the future risks and to explore how firms might respond to the materialization of these risks, rather than testing the capital adequacy of firms. The following are the key features of the Biennial Exploratory Scenario exercise:
- Multiple Scenarios that cover climate as well as macro-variables—To test the resilience of the financial system in UK against the physical and transition risks in three distinct climate scenarios. These cover taking early, late, and no additional policy action to meet global climate goals.
- Broader participation—Both banks and insurers are exposed to climate-related risks and the action of one will spill over to affect the other. For insurers, this exercise builds on the scenarios developed for this year’s insurance stress test.
- Longer time horizon—This exercise will use a thirty-year modeling horizon. This is because climate change, and the policies to mitigate it, will occur over a much longer timeframe than the normal horizon for stress testing. To make these scenarios credible and tractable, BoE proposes that the Biennial Exploratory Scenario examine firms’ resilience using fixed balance sheets, focusing on sizing the risks and the scale of business model adjustment required to respond to these risks, rather than testing the adequacy of firms’ capital to absorb those risks.
- Counterparty-level modeling—A bottom-up, granular analysis of counterparties’ business models split by geographies and sectors is proposed to accurately capture the exposure to climate-related risks.
- Output—BoE will disclose aggregate results of the resilience of the financial sector resilience to climate-related risk rather than individual firms.
The discussion paper outlines the key features of the 2021 Biennial Exploratory Scenario, including participation, nature of the scenarios, modeling horizon, and the reporting frequency. Participants would submit projections at every five-year point in the test horizon, a lower frequency than in traditional stress tests. This allows firms to model long-term climate-related risks in a proportionate way. The paper further describes the scenario narratives, details the scenario specification, and sets out the modeling approaches. Next, the paper sets out the approach to submissions of participants. This includes the reporting of risk exposures as well as the management actions participants may take within the scenario. To facilitate feedback on specific elements of the scenario design, there are targeted questions at the end of each chapter of the discussion paper. Full list of the discussion questions can be found in Annex 1 of the paper. Annex 2 provides some indicative sources of data, methodologies, and research that BoE will use to specify the scenarios and that may prove useful to participants in undertaking granular financial analysis.
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Comment Due Date: March 18, 2020
Keywords: Europe, UK, Banking, Insurance, Stress Testing, Biennial Exploratory Scenario Exercise, Proportionality, Reporting, Climate Change Risk, BoE
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