In a letter published on Wednesday this week, the Prudential Regulation Authority (PRA) has advised UK financial services firms that it expects them to have fully embedded their approach to management of climate-related financial risks by the end of 2021. In the high-level supervisory expectations the PRA issued on climate-related financial risks in April 2019 (explained in a previous blog post here), the PRA indicated that firms should have implementation plans in place by October 2019. It has now reviewed a large number of those plans, and highlighted areas in which it wants to see improvement. The implication is that there is a lot more to be done before the new 2021 deadline.
Separately, this week the Climate Financial Risk Forum (CFRF), which is made up of representatives from the financial services industry and co-chaired by the PRA and the Financial Conduct Authority (FCA), released a practical guide to assist financial services firms in managing climate risks. The four-part guide does not have the status of regulatory guidance, but explains firms’ current capabilities and sets out recommendations for best practice in risk management, scenario analysis, disclosure and innovation.
Together, these developments suggest that the initial period of light-touch regulation on climate change is over and that UK regulators now expect to see focused and measurable progress on the way that financial services firms are managing climate-related risks.
PRA’s areas of concern in firms’ management of climate risks
In its letter, the PRA acknowledged that firms’ management of climate risks should be proportionate to their business model (not necessarily just to their size, as smaller firms could be more exposed to climate risks than larger firms), but highlighted some overall areas in which firms’ implementation plans had fallen below its expectations. In particular, it considered that:
- Governance: Firms need a clearer strategic response. Climate management information should be communicated more consistently and actively discussed at board level, and firms need to demonstrate an appreciation of the breadth and magnitude of the physical and transition risks and a clearer understanding of their relationship to financial risks in firms’ businesses.
- Risk management: Although firms often found that metrics and quantification were the most challenging aspect of assessing climate-related financial risks, where science, data or tools are not yet sufficient to estimate the risks accurately, reasonable proxies and assumptions should be used. Firms’ risk management processes generally were only in the early stages of development.
- Scenario analysis: Firms have significant gaps in their capabilities, data and tools and have not yet integrated scenario analysis into their risk assessments. Meeting the 2021 deadline will require a material increase in firms’ capabilities in a relatively short period.
- Disclosure: Appetite for making disclosure is being limited by capabilities, and some firms are not yet making any disclosures.
The PRA also highlighted some of the things that the best and most well-developed plans had detailed, including allocating clear responsibility for climate risk to one Senior Manager Function holder, providing training for the board on climate risk where necessary so that the board was equipped to oversee it, tailoring scenario analysis to match firms’ businesses and addressing both physical and transition risks in that analysis, and publishing TCFD-format disclosures (with some firms now approaching fully comprehensive disclosures).
CFRF Guide on best practice and identification of key challenges
The CFRF’s guide takes the topics of risk management, scenario analysis and disclosure in much more granular detail than the broad categories outlined by the PRA in its letter, as well as the topic of innovation. The guide is intended to complement the regulatory framework, with practical tools, experience and case studies alongside recommendations for best practice. It also identifies the most challenging aspects of managing climate risk for financial services firms.
Unsurprisingly, the CFRF identifies the lack of available data (or reliable data) and tools as a key challenge for firms in all three areas of risk management, scenario analysis and disclosure. Other key challenges identified included:
- the lack of standardisation in metrics and calculation methodologies;
- conducting climate risk assessment in a way that is proportionate to a firm’s other risks such as capitalisation and liquidity risks (i.e. not overweighting or underweighting climate risk against other risks), and in a way which does not cause unintended consequences (i.e. not financing the transition could lead to precipitating defaults);
- accounting for the breadth and magnitude of physical and transition risks, where risks will likely be correlated and aggravated by tipping points in a non-linear way, so that the overall impact of the risks could be much larger;
- conducting analysis over very long and uncertain timeframes;
- accounting for cognitive bias, as when people consider scenario analysis they unconsciously consider the probability of a future event or outcome on the basis of how easily they can remember past events or imagine possible events; and
- making judgments about materiality, given that materiality is capable of being understood differently in different contexts.
The CFRF recognises that best practice is evolving quickly in this area and has indicated that it anticipates developing the guide over time.
While UK regulators’ expectations in relation to firms’ management of climate change are now increasing (and the UK regulators are leading the way in this area), many firms will find the CFRF’s guide helpful in meeting those increased expectations. The innovative way that the PRA and FCA are trying to drive change and increase understanding from within the industry via the CFRF indicates the importance of climate change on their agenda, and also shows that they understand climate change risks are very different from the other types of risks firms are accustomed to managing.
Further and more hard-edged rules are likely to follow – the FCA is already consulting on a listing rule which would require premium-listed issuers to make disclosures in line with TCFD on a comply or explain basis (as explained in more detail here), and it has indicated that it is considering whether a broader, potentially mandatory, rule on all regulated firms is appropriate.
