What banks and insurers need to know about the PRA’s latest guidance on effectively managing climate related risks (CP10/25 – update to SS3/19)

The long-awaited update to SS3/19 has been published by the Prudential Regulation Authority (PRA). As expected, the consultation paper (CP10/25) looks to close the gap between the BCBS Principles for the effective management and supervision of climate-related financial risks and best practice principles adopted across other jurisdictions.

The consultation paper (CP) aims to provide clarity on the PRA’s expectations for banks and insurers in managing climate-related risks—an issue that many firms have been seeking guidance on for some time.

The CP addresses where the PRA feels there is weakness in UK Banks’ and Insurers’ climate risk adoption and assessments, and while more clarity has added additional detail, there are core weaknesses the PRA has called out:

• Stronger governance, risk management, and board understanding
  • Provide better training and improved, regular information and insights.
  • Align to climate goals – if you have committed to goals, then demonstrate how you will achieve them
  • Enhance quantitative climate risk appetite statements by informing metrics and limits with analysis of the losses associated with a range of climate stress scenarios.
• The development and use of climate scenarios
  • Justify which scenarios are being used and explain how they align to stated net zero commitments, either at company or jurisdiction level.
  • Climate Scenario Analysis (CSA) should inform business strategy and impact on future profitability, and revenues under a central case scenario should be assessed.
  • Reverse stress testing should be incorporated to understand which scenario breaks the bank.
  • These should be included within ICAAP (banks) and ORSA (insurers) – which means you need to demonstrate capital adequacy.
• Data
  • Data gaps should be addressed – if they exist, they shouldn’t be a barrier to effective longer-term solutions.
  • Corporate assessments need to be better understood with a greater focus on the climate-related risks to which they are exposed.
• Capital and ECL adequacy
  • Using the specific example from climate scenarios above, the proposed supervisory statement has built upon the guidance from preceding Dear CFOs/Dear CEOs in this space and prescribed that lenders should be analysing the impacts of climate related risks and clearly demonstrate that they have sufficient coverage within capital and ECL.
  • Insurers should ensure that Solvency Capital Requirements (SCRs) incorporate the effects of climate-related risks across underwriting, reserving, market, credit, and operational risks.

How does this impact firms moving forward?

While the CP may look to have given firms a breather in terms of making net zero commitments – although this should not be taken lightly – the PRA have effectively asked firms that have made public commitments to better demonstrate how these are embedded within their business plan.

For those firms that haven’t made such commitments, jurisdiction level targets have been quoted, which means all firms will have to demonstrate the capability to transition to a net zero world.

So, what does good look like?

After the required gap analysis, firms will be looking to understand what is expected. The points below give an indication of what 4most believes good looks like and how change should be embedded throughout the business.

Climate scenarios

On Climate Scenarios firms should be looking to understand the economic impacts on their portfolios to better understand where the weakness lies. The largest impacts may be driven by transitional risk rather than physical risk, these scenarios should drive macro-economic impacts by sectors and regions and better understand and test the impacts on their business plans. As a minimum the PRA have made it clear they expect firms to factor in a transition to net zero either by their own public statements and the jurisdiction-level goals. Moving CBES on a year is no longer good enough.

Reverse stress testing should be incorporated in scenarios – this would allow assessments of key impacts and vulnerabilities and can drive business resiliency strategies and transition priorities, giving board and senior management confidence that the CSA and scenarios used to inform risk appetite limits are appropriate.

Whilst the guidance itself leaves room for further methodological prescription, the message is clear: firms should know their portfolios better than anyone and they should come up with solutions and scenarios to appropriately test, and fully understand, weaknesses in their approach to managing climate-related risks.

Credit risk appetite

We expect credit risk appetite to clearly articulate the risks material to firms and be controlled through metrics and limits that consider financial performance observed in scenario analysis. A common metric viewed in the UK is % EPC. On its own it means little – but what it drives is the ability for the UK housing market to be able to become efficient.

If a firm understands its exposure to these transition costs (e.g. the cost required to get a property to an EPC rating of C) it can understand how this may impact customers’ longer-term affordability or impact on house prices via CSA. This may be translated into lower-level targets to protect against over exposure, for example adopting metrics to limit exposure to high LTV lending for poorer EPC-rated properties.

Insurance

Insurers are expected to integrate climate-related risks into their existing risk frameworks where these risks may impact risk appetites of the business. This includes consistent incorporation into risk modelling, scenario analysis, and the setting of risk appetite thresholds.

As part of the Stress and Scenario Testing (SST) component of their Own Risk and Solvency Assessment\ (ORSA), firms should include CSA, unless the risks are demonstrably immaterial. For insurers applying the Matching Adjustment, internal credit assessments should account for all potential sources of credit risk—both qualitative and quantitative—from climate-related risks, where material.

To align with these expectations, insurers should conduct a gap analysis to identify any discrepancies between their current practices and the proposed standards, evaluate the materiality of climate risks to their business, and select appropriate scenarios for testing.

Proportionality

The CP no doubt focused on larger firms with proportionality again being called out – however smaller to medium firms should still consider what enhancements are needed as “the pack” will move and the risk of falling below an industry standard becomes greater.

As a minimum, we would expect a firm to have understanding of their current physical and transitional risks, and the ability to understand longer term impacts on their portfolio and business plans.

How 4most can help

4most are uniquely placed to support your firm with the integration of the supervisory statement. Having supported firms understand and embed climate regulation, including data and modelling, across the UK, Europe, UAE, and Australasia, we know what good, and ineffective, looks like, and can bring that experience and insight to your organisation.

Get in touch to learn more about how we can help – info@4-most.co.uk.