Sizing the risks of climate change: an interview with the Bank of England’s Sarah Breeden

Understanding the long-term financial risks of climate change is step one in making the transition to a carbon-neutral economy, as the Bank of England’s Sarah Breeden explains.

Anne Murphy, Head of Odgers Berndtson’s Financial Services Practice, in conversation with the Bank of England’s Executive Director who oversees the Bank’s work enhancing the financial system’s resilience to climate change. A video of this interview is available here.

Anne Murphy: You have oversight of the Bank's work around climate risk. Could you tell us a little bit more about that?

Sarah Breeden: So we started thinking about the risks that climate change might pose back in 2015 when we started by looking at the impact of climate change on the insurance sector. That was an obvious place to start. Lloyd's of London is in the business of insuring weather all around the world. And that was where we started.
But, of course, you then realise that this is an issue, not just for insurers, but for banks, for asset managers, for all parts of the financial system. Our work has very much expanded from there.

AM: Can you give us a sense of the financial risks resulting from some of these issues?

SB: We categorise the financial risks under two different risk channels.

The first is a physical risk. That's the damage that happens to land, to property, to infrastructure, from weather-related events. That might be Yorkshire floods or Australian bush fires. But it could also just be from chronic changes in temperature and the impact of that, like the rises in sea level that we might see. The other risk channel is transition risk, and that would arise from the changes in government policy and technology, just as indeed, in consumer behaviour, as we move towards a net-zero economy.

Now people know that that affects fossil fuel and energy companies and that there's the potential for stranded assets and unburnable carbon because the amount of fossil fuels that we've discovered is bigger than the carbon budget that our one and a half or two-degree world needs.

But actually that need to transition is much, much broader.

Every single asset on the planet will have a different value in a world of net-zero.

It affects infrastructure, it affects properties, it affects transport, it even affects agriculture. And so that need to transition is a very broad-based risk.

AM: And is it fair to say that those transition risks are less well understood?

SB: I think they're harder to understand because we know that we need to get to net-zero and to stabilise the planet, the atmosphere in the planet. But what we don't know is how to get there and what changes are going to be made. Government policy is very clear on the intent. 195 countries signed up to the Paris Agreement, but how we're going to get there is unclear, and therefore it's harder to see where that transition risk might arise.

AM: And what do you see as being the biggest hurdles for financial institutions in trying to help overcome some of those risks?

SB: So the first thing they need is good data from the companies that they lend to, insure, and invest in. If they haven't got the data from those companies as to how those companies and those consumers are all preparing for a net-zero world or more physical risk in future, the financial institution can't possibly understand the risk.

So, step one is all about data and reporting.

The FSB's Task Force on Climate-Related Financial Disclosures has set out some recommendations about what good disclosure looks like, and we need to get meaningful, comparable, consistent, decision-useful information to get to the banks, the insurers and the investors on that, to help them size that risk.

But that's only step one.

Once you've got the data, you've then got to develop the risk assessment methodologies to understand how to price that risk and size that risk. And that's much easier said than done.

We're in a much better place now than we were many years ago.

But this, at its heart, is a forward-looking risk.

What matters is what is going to happen in the future, what companies' strategies are to deal with these risks over the next 10, 20 years. So looking ahead, 10 or 20 years, that's just hard.

AM: What role can central banks and regulators play in that?

SB: So, I think we've got a really important role to play on two dimensions.

The first is telling financial institutions that this is a financial risk. Being clear that it's not just about the damage to the environment and the planet. It's about the damage to their balance sheets as well.

We can also be very clear about what they should do about it. The sorts of expectations that we've put in place, as a supervisor of banks and insurers, relates to governance and risk management. These issues need to be embedded in governance and risk management, just like all other risks. And also we can emphasise that firms should undertake scenario analysis and disclosure so that they know what risks they might see in the future.

The other thing that we can do, and this is really important, is help give them the tools to do that analysis, that risk analysis, and that scenario analysis better.

And, in fact, we recently launched a discussion paper on a climate-related stress test that we are proposing to do of UK banks and UK insurers. This is designed to help them get the data and develop the risk assessment methodology so that they know the future financial risks that they are going to face.

AM: Tell us more about the timing that you expect for the stress test, and how you think firms are doing with regards to disclosure, particularly.

SB: So the exercise that we announced is absolutely pioneering. It's something that has never been attempted before.

The Bank is consulting on the design of the stress test and welcomes feedback on the feasibility and the robustness of these proposals from firms, their counterparties, climate scientists, economists and other industry experts by 18 March 2020. The final BES framework will be published in the second half of 2020 and the results of the exercise will be published in 2021.

What we are going to do is set out some scenarios, and we're going to set out three different scenarios, and we're going to ask firms to model their balance sheets under each of those three scenarios.

And what we want them to go and do is go and have conversations with their customers, get the information from their customers, to help them understand the risks to which they are exposed in a world where we don't meet the two-degree target.

Or, and alternatively in two other outcomes, one where there's an orderly transition to a temperature outcome of well below two degrees and one where there's a disorderly transition. So that's what firms will be doing.

What's fundamental to that is good reporting, good data from their clients. The analysis that has been done so far of how well the TCFD recommendations have been embedded suggests that what firms are doing now, the corporates in the real economy, what they're doing is explaining qualitative strategies and how they're governing it.

But they're not giving the banks, the insurers, the investors, the hard data about how they are going to amend their strategy, and what financial risks they are exposed to. And in fact, the scenarios that we published as part of this exercise, will give them a basis on which to analyse their business.

So, I'm hopeful that in addition to being useful to the banks and insurers in helping them size these risks, this exercise and the scenarios that we will produce will also be useful to investors and to the corporates in supporting effective, useful disclosure.

AM: Thank you, Sarah, we’ll pick up the subject of how supervisory expectations are changing around managing climate risk, and the roles of leadership and boards in the race to zero carbon in the next part of this interview.