On 29 June 2020, the Climate Financial Risk Forum (CFRF) published its first guide to aid financial institutions in their approach to climate-related financial risks (the Guide). This Alert summarises the key points proposed in the Guide.
The CFRF was set up by the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) as an industry forum to develop practical tools for financial institutions to respond to climate-related financial risks. Financial institutions are increasingly facing both ‘physical’ risks1 as the climate changes and ‘transition’ risks2 as the economy moves to a net-zero carbon economy.
The purpose of the Guide is to:
- aid financial institutions in understanding the risks and opportunities that arise from climate change;
- support financial institutions in how they adapt their risk, strategy and decision-making processes to reflect climate-related financial risks; and
- help financial institutions plan how to deal with the impact of climate policies, and assess their exposure to climate-related financial risks and adapt their business in response.
The Guide has been designed to be complementary to existing initiatives, such as the UN-supported Principles for Responsible Investment and the Taskforce on Climate-related Financial Disclosures. Although the PRA and FCA have convened and facilitated CFRF discussions, the views in the Guide do not constitute regulatory guidance.
The Guide includes a summary co-produced by the FCA and PRA and four industry-produced chapters.
This chapter focuses on how financial institutions can appropriately embed climate-related financial risk into their governance and risk management processes, so that they can make informed business decisions and improve their resilience.
It is designed to be read alongside the PRA’s supervisory statement SS3/19 on enhancing banks’ and insurers’ approaches to managing the financial risks from climate change and the FCA’s requirements for solo-regulated financial institutions including how external factors can impact on strategy and visibility as discussed in CP19/20.
This chapter focuses on how financial institutions should use scenario analysis to assess climate-related financial risks. It provides helpful examples of how financial institutions should develop appropriate modelling and emphasises the need for them to consider a range of possible climate scenarios, so that they can better understand and manage future risks now, whilst also capturing opportunities to support the transition to a net-zero carbon economy in the future.
According to the Guide, a climate scenario can typically be described using a combination of the following components:
- socioeconomic context;
- technological evolution;
- climate policy landscape; and
- emissions pathways and associated changes in the physical atmosphere.
Financial institutions may choose to analyse only one of these components or they may decide that their analysis should cover several.
This chapter should be read in conjunction with:
- the PRA’s supervisory statement SS3/19;
- the outputs of the PRA’s 2021 Biennial Exploratory Scenarios;
- the FCA’s consultation paper CP19/20;
- the scenario analysis in the Prudential sourcebook for investment firms; and
- the Network for Greening the Financial System’s publication on scenario analysis and reference scenarios.