Prudential Regulation Authority Rulebook

2.1

Financial risks from climate change arise through two primary channels, or ‘risk factors’: physical and transition. These manifest, for example, as increasing underwriting, reserving, credit, or market risk for firms.

2.2

The PRA’s report on the impact of climate change on the UK insurance sector identified a third risk factor – liability risks – arising from parties who have suffered loss or damage from physical or transition risk factors seeking to recover losses from those they hold responsible. The legal risks from climate-related liabilities can be of particular importance to insurance firms given these risks can be transferred through liability protection, such as directors’ and officers’ and professional indemnity insurance. Given these legal risks arise from physical or transition risk factors and the distinctive elements discussed in paragraph 2.5, they are referred to within the more detailed discussion of the two risk factors below.

2.3

Physical risks from climate change arise from a number of factors, and relate to specific weather events (such as heatwaves, floods, wildfires and storms) and longer-term shifts in the climate (such as changes in precipitation, extreme weather variability, sea level rise, and rising mean temperatures). Some examples of physical risks crystallising include:

• increasing frequency, severity or volatility of extreme weather events impacting property and casualty insurance; and
• increasing frequency and severity of flooding leading to physical damage to the value of financial assets or collateral held by banks, such as household and commercial property. This can lead to increased credit risks, particularly for banks, or to underwriting risks for liability insurers if it results in legal claims to recover financial losses from this physical damage.

2.4

Transition risks can arise from the process of adjustment towards a low-carbon economy. A range of factors influence this adjustment, including: climate-related developments in policy and regulation, the emergence of disruptive technology or business models, shifting sentiment and societal preferences, or evolving evidence, frameworks and legal interpretations. Some examples include:

• tightening energy efficiency standards for domestic and commercial buildings impacting the risk in banks’ buy-to-let lending portfolios;
• rapid technological change, such as the development of electric vehicles or renewable energy technology, affecting the value of financial assets in the automotive and energy sector; and
• companies in the wider economy that fail to mitigate, adapt, or disclose the financial risks from climate change being exposed to climate-related litigation, which could impact their market value or lead to higher claims for insurers that provide liability cover to those companies.

2.5

The financial risks from climate change have a number of distinctive elements which, when considered together, present unique challenges and require a strategic approach to financial risk management. These elements include:

• Far-reaching in breadth and magnitude: The financial risks from physical and transition risk factors are relevant to multiple lines of business, sectors, and geographies. Their full impact on the financial system may therefore be larger than for other types of risks, and is potentially non-linear, correlated and irreversible.
• Uncertain and extended time horizons: the time horizons over which financial risks may be realised are uncertain, and their full impact may crystallise outside of many current business planning horizons. Using past data may not be a good predictor of future risks.
• Foreseeable nature: while the exact outcome is uncertain, there is a high degree of certainty that financial risks from some combination of physical and transition risk factors will occur.
• Dependency on short-term actions: the magnitude of future impact will, at least in part, be determined by the actions taken today. This includes actions by governments, firms, and a range of other actors.

2.6

The magnitude of the financial risks from climate-related factors will depend on future scenarios that will, at least in part, be determined by actions taken today. A ‘too little, too late’ scenario, where significant action is taken, but too late to achieve climate goals, could result in the most severe financial risks crystallising in the banking and insurance sectors. Financial risks from climate change will be minimised if there is an orderly market transition to a low-carbon world, but the window for an orderly transition is finite and closing.