Prudential Regulation Authority Rulebook

3.1

The PRA expects a firm’s response to the financial risks from climate change to be proportionate to the nature, scale, and complexity of its business. As a firm’s expertise develops, the PRA expects the firm’s approach to managing the financial risks from climate change to mature over time. The PRA intends to embed the measurement and monitoring of these expectations into its existing supervisory framework.

3.2

The PRA expects a firm’s board to understand and assess the financial risks from climate change that affect the firm, and to be able to address and oversee these risks within the firm’s overall business strategy and risk appetite. The approach should demonstrate an understanding of the distinctive elements of the financial risks from climate change and a sufficiently long-term view of the financial risks that can arise beyond standard business planning horizons.

3.3

Where appropriate, the PRA will expect to see evidence of how the firm monitors and manages the financial risks from climate change in line with its risk appetite statement. The risk appetite statement should include the risk exposure limits and thresholds for the financial risks that the firm is willing to bear, and should take into account factors such as:

• long-term financial interests of the firm, and how decisions today affect future financial risks;
• results of stress and scenario testing, for shorter and longer time horizons;
• uncertainty around the timing and the channels through which the financial risks from climate change may materialise; and
• sensitivity of the balance sheet to changes in key risk drivers and external conditions.

3.4

The PRA expects firms to have clear roles and responsibilities for the board and its relevant sub-committees in managing the financial risks from climate change. In particular, the board and the highest level of executive management should identify and allocate responsibility for identifying and managing financial risks from climate change to the relevant existing Senior Management Function(s) (SMF(s)) most appropriate within the firm’s organisational structure and risk profile, and ensure that these responsibilities are included in the SMF(s)’s Statement of Responsibilities. The PRA expects to see evidence that the board and its relevant sub-committees exercise effective oversight of risk management and controls. Further, the PRA expects the board to ensure that adequate resources and sufficient skills and expertise are devoted to managing the financial risks from climate change.

3.5

The PRA expects firms to address the financial risks from climate change through their existing risk management frameworks, in line with their board-approved risk appetite, while recognising that the nature of the risks requires a strategic approach. In a manner proportionate to their business, firms should identify, measure, monitor, manage, and report on their exposure to these risks. Firms should be able to evidence this in their written risk management policies, management information, and board risk reports. This includes, where appropriate, updating existing risk management policies.

3.6

The PRA expects firms to understand the financial risks from climate change and how they will affect their business model. Firms should use scenario analysis and stress testing to inform the risk identification process and understand the short- and long-term financial risks to their business model from climate change. Firms are also expected to go beyond using only historical data to inform their risk assessment, for example by considering future trends in catastrophe modelling. The PRA expects that such scenarios will develop and mature over time as firms learn from experience and each other.

3.7

As part of the Internal Capital Adequacy Assessment Process (ICAAP) or Own Risk and Solvency Assessment (ORSA), firms should include at a minimum:

• all material exposures relating to the financial risks from climate change; and
• an assessment of how firms have determined the material exposure(s) in the context of their business.

3.8

Where appropriate, the PRA expects firms to consider a range of quantitative and qualitative tools and metrics to monitor their exposure to financial risks from climate change. For example, these could be used to monitor exposures to climate-related risk factors which could result from changes in the concentration of firms’ investment or lending portfolios, or to the potential impact of physical risk factors on outsourcing arrangements and supply chains. The PRA expects that these metrics and tools will evolve and mature over time as firms gain experience.

3.9

Firms should also use these metrics to monitor progress against their overall business strategy and risk appetite. The metrics should be updated regularly to support decision making by the firm’s board and/or relevant sub-committees. Firms should set out circumstances which would trigger a review of its strategy for addressing the financial risks from climate change.

3.10

Where the potential impacts of the financial risks from climate change are assessed to be material (for example as a result of scenario analysis), the PRA expects firms to evidence how they will mitigate these financial risks and to have a credible plan or policies in place for managing exposures. This could include actions the firm is taking to reduce concentrations of these risks. Plans should be reflective of the distinctive elements of the financial risks from climate change, so may differ from other risks.

3.11

For Solvency II insurers, under the Prudent Person Principle (PPP) an undertaking should only invest in assets for which risks can be identified, measured, monitored, managed, controlled, and reported.¹⁴ A key requirement of the PPP for the purposes of this SS is that, where insurers bear the investment risk, insurers must diversify their assets to avoid excessive accumulation of risk in the investment portfolio. Solvency II insurers should therefore consider whether there is an excessive accumulation of financial risks from climate change (particularly those likely to crystallise via the transition risk factor) in their investment portfolio, and consider mitigants when this is the case.

3.12

To inform their risk assessment and management, firms should seek to understand the potential current and future impacts of the physical and transition risk factors on their clients, counterparties, and organisations in which the firm invests or may invest. To the extent that firms do not have the necessary information, firms are expected to engage with clients and counterparties where this information is considered material to a firm’s own risks. Firms could also consider using data from publicly available sources or working together with external experts to collect (asset-level) data.

3.13

The PRA expects firms to provide the board and relevant sub-committees with management information on their exposure to the financial risks from climate change, for example, based on scenario analysis and the mitigating actions and associated timeframe the firm proposes to take. The management information should enable the board to discuss, challenge, and take decisions relating to the firm’s management of the financial risks from climate change.

3.14

Where proportionate, the PRA expects firms to conduct scenario analysis to inform their strategic planning and determine the impact of the financial risks from climate change on their overall risk profile and business strategy. Scenario analysis should also be used to explore the resilience and vulnerabilities of a firm’s business model to a range of outcomes. The PRA expects approaches to scenario analysis to evolve and mature over time.

3.15

The PRA expects a firm’s scenario analysis to address a range of outcomes relating to different transition paths to a low-carbon economy, and a path where no transition occurs. The scenario analysis should, where appropriate, include a:

• short-term assessment which sets out the firm’s exposure to the financial risks from climate change within its existing business planning horizon, including, where appropriate, the quantification of these risks; and
• longer term assessment of the firm’s exposure, based on its current business model, of a range of different climate-related scenarios. For example: scenarios based around average global temperature increases consistent with, or in excess of 2˚C; and scenarios where the transition to a low-carbon economy occurs in an orderly manner, or not. The PRA expects the time horizon of this long-term assessment to be in the order of decades. As with other types of scenario analysis, this is not intended to be a precise forecast, but a qualitative exercise used to inform strategic planning and decision making.

3.16

The PRA expects firms to use these scenarios to understand the impact of the financial risks from climate change on their solvency, liquidity and, for insurers, their ability to pay policyholders. Where a firm relies on management actions to mitigate the financial risks from a scenario, it should consider whether these are realistic, credible, consistent with regulatory expectations, and achievable. For example, it should not rely on the existence of a liquid market to sell the assets it has identified as being exposed. Firms should also consider whether any of the actions identified should be taken in advance as precautionary measures, or whether they would be relevant or desirable only if the scenario emerges.

3.17

The PRA considers the ORSA for insurers, and the ICAAP for banks, to be useful frameworks within which to consider the financial risks from climate change. For insurers, Solvency II states that consideration of the long term is essential to insurers being able to assess their ability to continue as a going concern. For banks, the SS on the ICAAP¹⁵ sets out that scenario analysis should be used to explore the sensitivities in longer-term business plans. Scenario analysis is a key tool that the PRA expects firms to employ as part of that assessment.

3.18

Banks and insurers have existing requirements to disclose information on material risks within their Pillar 3 disclosures (as required under Capital Requirements Regulation (575/2013) (CRR) and Solvency II), and on principal risks and uncertainties in their Strategic Report (as required under the UK Companies Act).

3.19

In addition to meeting these existing disclosure requirements, firms should consider whether further disclosures are necessary to enhance transparency on their approach to managing the financial risks from climate change, in line with the expectations set out in this SS. In particular, all firms within the scope of this SS should consider disclosing how climate-related financial risks are integrated into governance and risk management processes, including the process by which a firm has assessed whether these risks are considered material or principal risks.

3.20

The PRA expects firms to develop and maintain an appropriate approach to disclosure, reflective of the distinctive elements of the financial risks from climate change. Firms should look to evolve their disclosures to make these as insightful as possible, and in particular should ensure they reflect the firms’ evolving understanding of the financial risks from climate change. Firms should recognise the increasing possibility that disclosure will be mandated in more jurisdictions, and prepare accordingly.

3.21

The PRA expects firms to engage with wider initiatives on climate-related financial disclosures and to take into account the benefits of disclosures that are comparable across firms. Various initiatives have done work on this area. For example, the ‘Taskforce on Climate-related Financial Disclosures’ published recommendations in June 2017,¹⁶ and other initiatives have since then provided tools or case studies for organisations making climate-related financial disclosures. The PRA expects firms to consider engaging with the TCFD framework and other initiatives in developing their approach to climate-related financial disclosures.

3.22

In addition, firms would benefit from greater disclosure in the wider economy, and they would be in a strong position to encourage it through their ownership of financial assets.