The FCA reports on climate change adaptation challenges for UK financial services firms

The FCA identifies climate adaptation challenges for financial services firms

Every five years, the UK government produces an assessment of risks and opportunities from climate change and explains the actions it will take in response. As part of this process, the Department for Environment, Food and Rural Affairs (DEFRA) invited the FCA to report on challenges faced by the financial services firms it regulates. 

The FCA’s findings, published on 28 January in The Financial Conduct Authority’s Adaptation Report, are based on informal engagement with firms and the FCA’s understanding of market dynamics. 

What is climate change adaptation and how is it regulated?

The report uses the explanation of climate adaptation provided by the government:

“Climate adaptation relates to actions that protect us against the impacts of climate change. This includes reacting to changes we have seen already, as well as preparing for what will happen in the future”

The FCA considers that adaptation poses risks to financial markets, but the report itself does not set out regulatory expectations for firms and is not intended as a comprehensive assessment of the issues. 

However, existing regulatory requirements do of course already include provisions to ensure identification and management of risks and the operational resilience of critical financial services, which will also be relevant to climate risks. Where applicable (including for asset managers, FCA regulated asset owners and UK listed companies), firms must also disclose climate risks in line with the Task Force on Climate-Related Financial Disclosures recommendations (TCFD) (expected to be superseded for listed companies later this year by standards produced by the International Sustainability Standards Board (ISSB)). 

We note that the FCA is keen to ensure its approach to regulating climate adaptation balances the need for firms to manage their own risks with the consequences of risk management measures on consumers and markets.

Key challenges for financial services firms

The FCA lists three major issues affecting climate change adaptation in the financial services industry: 

• Availability of data and models to assist with quantification and management of climate risks.
• Barriers and enablers to insurance underwriting for climate risks and, in consequence, lending and investment.
• Barriers and enablers to allocation of capital for climate adaptation.

The FCA also identifies the need to protect critical infrastructure, in particular IT systems, while making sure climate transition plans consider adaptation.

The report goes on to identify concerns related to the continued availability and affordability of financial products in areas at significant risk of climate related damage. We consider the issues raised by the FCA in further detail below. 

Data and models to manage climate risks

Firms need high quality data and models to assess and price climate-related risks with sufficient accuracy. The FCA has identified the current availability and quality of data and models as a major challenge. 

Whilst models have been developed by firms for specific purposes, aggregation or repurposing of data may be unreliable. Other challenges include a hesitation to share commercially valuable data, unpredictability of UK hazard data for longer term risks (compared to the more available hazard data for short term risks within five years), as well as gaps in and unavailability of data in areas such as overseas risks. In addition, data may not be obtainable in a format that can be readily used for decision-making.

Drawing on the recommendations of the Climate Financial Risk Forum, the FCA sets out a number of enablers to adaptation. These include identifying data gaps, creating portals and tools to improve risk assessment, improving quality and standardisation of data, producing more holistic information and pooling expertise through collaboration within the finance industry, utilities firms, academia and scientific bodies. 

Insurance underwriting for climate risks and related risks for lenders

Climate-related natural disasters have led to significant increases in insurance claims in recent years. Insurers undoubtedly have an important role in promoting risk management, but have no control over major infrastructure projects (e.g. coastal defences), which are the responsibility of local and central government. In addition, certain risks may be uninsurable (or insurance may be limited), including coastal or riverbank erosion, drought, rises in sea-levels and impacts of extreme heat. It is noted that insurers often adapt after a loss has been suffered rather than beforehand based on risk modelling.

Climate related events also increase risks to lenders and impact availability of mortgage and commercial lending. These risks become elevated if insurance is restricted or unavailable. Lenders must therefore develop their own methodologies and cannot rely on insurance as a basis for lending decisions.

Whilst traditional insurance remains the main form of risk funding for UK property, the FCA believes capital market alternatives may be found in the form of catastrophe bond issuances. These products primarily cover overseas and large industrial risks, but the FCA suggests a challenge would be to make them workable for homeowners. This may be of particular relevance once the Flood Re scheme (currently providing affordable reinsurance to cover the risk of exceptional flooding) comes to an end in 2039, which may make insurance unavailable or unaffordable for many consumers. 

Based on its findings, the FCA believes the future insurability of properties and availability of lending needs to be carefully considered. To improve resilience of properties to flooding and other climate-related risks, and maintain a stable provision of financial products, greater co-ordination between stakeholders and better information for households will be required.

Allocation of capital to climate adaptation

Banks and capital markets (e.g. via green bonds) can play an important role in funding adaptation by lending to businesses and homeowners. However, the FCA highlights that funding adaptation has several challenges, including the duration of the contract. 

Firms could potentially require adaptation as a condition of lending or insurance, but this is typically limited to large insurance policies or loans. With available data usually limited to geographical areas, the cost of verifying resilience for a particular property may be prohibitive, which could exacerbate adaptation funding concerns in high risk areas.

Although financial services firms can promote adaptation, the sector is reliant on government to take action (such as constructing flood or coastal defences) and has limited influence on planning. The FCA therefore believes co-ordination between firms, government, construction and utilities will be key to enable continued funding.

Embedding adaptation in transition plans and risk assessments

The FCA notes that firms could use transition planning to assess the impact of climate change on their operations and hence how they will adapt. The FCA’s TCFD regime encourages listed companies and relevant firms to draw up robust climate transition plans. The FCA has also contributed to the UK Transition Plan Taskforce (TPT), which considered the need for adaptation. Responsibility for the TPT framework has passed to the ISSB, and the FCA is expected to consult on the ISSB’s standards once they are adopted in the UK later this year. At the same time, it will also consult on strengthening expectations for transition plans with reference to the TPT framework.

Whilst firms clearly need to ensure that they adapt their risk assessment to consider climate change, the FCA understands that this assessment needs to be accompanied by adaptation in the wider economy if financial services firms are to continue to fulfil their economic roles, including funding of adaptation and transition.