The Bank of England has published the Climate Biennial Exploratory Scenario (CBES) to explore the financial risks posed by climate change for the largest UK banks and insurers.

The CBES uses three scenarios of early, late and no additional action to explore the following two key risks from climate change:

• transition risks - the risks arising from the significant structural changes to the economy needed to achieve net zero emissions
• physical risks - risks associated with higher global temperatures

This is the first time the Bank is testing both banks and insurers to allow it to capture interactions between them and understand the risks presented by climate change across the financial system.

The CBES examines three scenarios of early, late and no action built on a subset of the Network for Greening the Financial System (NGFS) scenarios: these are applied over a span of thirty years reflecting the longer-term nature of climate-related risks.

1. Early Action: the transition to a net-zero economy starts in 2021 so carbon taxes and other policies intensify relatively gradually over the scenario horizon. Global carbon dioxide emissions are reduced to net-zero by around 2050. Global warming is limited to 1.8°C by the end of the scenario (2050) relative to pre-industrial levels. Some sectors are more adversely affected by the transition than others, but the overall impact on GDP growth is muted, particularly in the latter half of the scenario once a significant portion of the required transition has occurred and the productivity benefits of green technology investments begin to be realised.

2. Late Action: The implementation of policy to drive the transition is delayed until 2031 and is then more sudden and disorderly. Global warming is limited to 1.8°C by the end of the scenario (2050) relative to pre-industrial levels. The more compressed nature of the reduction in emissions results in material short-term macroeconomic disruption.

This affects the whole economy but is particularly concentrated in carbon-intensive sectors. Output contracts sharply in the UK and international economies. The rapid sectoral adjustment associated with the sharp fall in GDP reduces employment and leads to some businesses and households not being able to make full use of their assets, with knock-on consequences for demand and spending. Risk premia rise across multiple financial markets.

3. No Additional Action – this scenario primarily explores physical risks from climate change where no new climate policies are introduced beyond those already implemented.

The absence of transition policies leads to a growing concentration of greenhouse gas emissions in the atmosphere and, as a result, global temperature levels continue to increase, reaching 3.3°C relative to pre-industrial levels by the end of the scenario. This leads to chronic changes in precipitation, ecosystems and sea-level.

There is also a rise in the frequency and severity of extreme weather events such as heatwaves, droughts, wildfires, tropical cyclones and flooding. There are permanent impacts on living and working conditions, buildings and infrastructure. UK and global GDP growth is permanently lower and macroeconomic uncertainty increases.

Changes in physical hazards are unevenly distributed with tropical and subtropical regions affected more severely. Many of the impacts from physical risks are expected to become more severe later in the 21st century and some will become irreversible.

CBES aim is to size the risks participants face based on their current (fixed) balance sheets

The aim is to size the risks participants face based on their current (fixed) balance sheets - for banks, the exercise will focus on their credit books, whilst for insurers, the exercise will assess risks to both their assets and liabilities.

The CBES will:

• Size the financial exposures of individual firms and the financial system to their end-2020 balance sheets: this will shine a light on risks that are currently opaque;
• Understand business model challenges and likely responses to these risks: this will highlight where action may be needed and any implications for the provision of financial services, and
• Improve firms’ risk management and prompt a strategic view: this includes building capability, both amongst participants and within the Bank.
• The exercise will also encourage participants to engage their largest counterparties to understand their vulnerability to climate change.

The CBES is a learning and exploratory exercise and will not be used by the Bank to set capital requirements. Experience and expertise in modelling climate-related risks is still relatively immature,the Bank said, so the exercise will develop the capabilities of both the Bank and the CBES participants.

Andrew Bailey the Governor of the Bank of England said:

“Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole. It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks. It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”

Sarah Breeden, the Bank of England Executive Sponsor for climate change added that the new climate scenarios build upon the second iteration of NGFS scenarios released yesterday and would provide central banks and supervisors around the globe with a common starting point for analysing climate risks under different future pathways.

She described climate scenario analysis as “a critical part of the Bank’s toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system.”

The Bank said the CBES scenarios are not forecasts of the most likely future outcomes. Instead, the scenarios are plausible representations of what might happen based on different future paths of governments’ climate policies (policies aimed at limiting the rise in global temperature). Each scenario is assumed to take place over the period 2021–50.

The Bank expects to publish the CBES results in May 2022.

Click here to access the Bank of England key elements 2021 biennial exploratory scenario financial risks climate change

Click here to access the Network for Greening the Financial System (NGFS) scenarios