Climate change is a shared challenge for all of us.  As our world comes together to rise to the challenge, banks and investors recognise the pivotal role they play in limiting the global average temperature rise to the international goal of well below 2°C.

This transition will bring challenges for banks that currently finance activities that are more exposed to climate change , for example lending to households in areas susceptible to increased flooding. It will also bring opportunities, as they increase lending to green and low-carbon projects such as enhancing energy efficiency of the existing housing stock or low-carbon power generation by wind or wave farms.

As well as playing their part in the introduction of new technologies banks, as prudent institutions, must also be aware of the economic and financial risk that climate change will bring. They and their supervisors use stress testing to test their resilience to severe but plausible shocks, to ensure they have sufficient capital to weather the increased financial and economic risks climate change will bring.

The challenge of stress testing the impact of climate change is significant, as the range of possible pathways and climate outcomes are multifactorially dependent and will play out over many decades.

So the joint discussion paper the Prudential Regulation Authority (PRA) and Financial Policy Committee (FPC) released just before Christmas, confirming that the 2021 Biennial Exploratory Scenario (BES) stress test will explore the risks posed by climate change, is welcome.

The discussion paper recognises that, given the unique and long-term risks posed by climate change, the 2021 BES will be a novel and complex exercise for the largest banks, building societies and insurers as well as for the Bank of England itself. So, the BES proposal differs from a traditional stress test by:

• Extending the modelling horizon from the usual five years to thirty years
• Subjecting participating firms to three scenarios, which are:

• Early policy action which limits global temperature increase to below 2°C
• Late policy action where it is assumed that actions are delayed by ten years but then implemented urgently to successfully limit temperature increases to below 2°C, but with a significant degree of disruption to the global economy
• No additional policy action, with the result that global average temperature increases substantially by 2080, with attendant physical rather than transition risks predominantly materialising by 2050.

The discussion paper confirms that the 2021 BES will build on reference scenarios being developed by the Network for Greening the Financial System and will be based on current balance sheets. It also confirms that the 2021 BES may include a second round of submissions.

Whilst only the largest banks and insurers are subject to the BES, the discussion paper will be of interest to all UK Finance members subject to PRA supervision. Firms are expected to understand how financial risks from climate change may affect the firm and its business strategy and risk profile, and will have recently allocated this responsibility to an existing Senior Management Function.

UK Finance will respond to the Climate Change Discussion Paper by the 18 March deadline. All member banks and building societies are invited to contribute to this by contacting Simon Hills.