In the toughest climate stress test so far for financial sector firms, the Bank of England concluded that delaying action on climate risks will add billions to the tab.
The British central bank published the results of its latest biennial climate scenario analysis, which explores the financial risks posed by climate change for the largest banks and insurers in the U.K.
Ahead of the report’s release, Fitch Ratings described the test as the toughest to date by a central bank. The central bank examined three possible approaches to climate risks: early action to net zero by 2050, late action, and no action.
“The BoE test is tougher than last year’s French climate test,” the rating agency said. “It assumes higher peak carbon prices and greater global warming, and it limits credit for the management actions that firms could take to mitigate the effect of the scenarios on their business models.”
Under these scenarios, some institutions’ capital ratios would likely to fall close to, or even below, regulatory minimums, Fitch said. The “early action” scenario causes the least stress, while “late action” incurs the greatest transition risks and “no action” invites the largest physical risks.
Overall, the central bank concluded that banks and insurers “are likely to be able to absorb the costs of transition that fall on them,” but that the costs will be lowest with early action to reduce greenhouse gas emissions and limit climate change.
Specifically, it found that banks’ projected climate-related credit losses were 30% higher in the “late action” scenario.
“Loss rates in the [late action] scenario were projected to more than double as a result of climate risks — equivalent to an extra £110 billion of losses for participating banks over the period,” it said.
The key drivers of these losses were “the large increase in carbon prices contained in this scenario, which leads to large corporate loan losses across energy users and energy producers, and the economy-wide recession, including a rise in unemployment and fall in house prices caused by the sharp adjustment process, leading to significant mortgage impairments.”
The test found that these added losses were heavily concentrated in the first five years of a delayed transition.
Banks and insurers are likely able to “absorb the climate costs which fall on them without material risks to solvency, but will face significant headwinds and therefore need to continue to invest in their ability to support the economy’s transition to net zero,” said Sam Woods, deputy governor for prudential regulation and CEO of the Prudential Regulation Authority (PRA), in a release.
Fitch noted that climate stress tests are becoming more mainstream for banks and insurers around the world, and that the outcomes of these tests could eventually feed into firms’ capital requirements.
The PRA will report by the end of this year on whether changes to the U.K.’s regulatory capital regimes may be required to explicitly capture climate risks, Fitch said.