Thematic feedback on the PRA’s supervision of climate-related financial risk

2022 is the first year in which the PRA has been actively supervising firms against its expectations on climate-related financial risk. Now, hot on the heels of the Bank of England/PRA climate and capital conference, its Dear CEO letter to banks and insurers sets out thematic feedback on how they have adapted to and satisfied the expectations first set out three years ago in Supervisory Statement 3/19 (SS3/19).

The overarching finding is that firms have taken “concrete and positive steps” to implement expectations. Recognising firms' investment in their efforts to manage climate risk, the PRA notes that governance and risk management practices have advanced, as have disclosures. Scenario analysis is less well developed, and data gaps and limitations persist, but it has observed examples of effective practice. As firms' understanding and approaches mature, we can expect the supervisory bar to be raised.

The PRA finds that firms have made “significant progress” in embedding its supervisory expectations around governance. Firms have generally implemented an effective level of climate governance, trained appropriate key personnel to both understand and manage this risk, and are producing management information that allows Executive teams and Boards to lead and challenge in this area. The most effective firms demonstrate strong Board and Executive oversight through a coherent approach to, and understanding of, business strategies, planning, governance and risk management processes, supported by appropriate metrics and risk appetites. Most firms have given overall responsibility of climate-related financial risk to a Senior Management Function (SMF) holder — the PRA regards this as positive step but cautions that SMFs should be able to speak to and take appropriate ownership of the broad institutional strategy for climate risks.

Firms have generally made progress on risk management processes, though the maturity of those processes varies, and all firms have more work to do. In many cases, climate risk considerations still need to be embedded fully into overall risk management frameworks (RMF), risk appetite statements (RAS), committee structures and all three lines of defence, using both quantitative and qualitative measures. Effective practice will include:

• Having a well-defined quantitative RAS that is aligned with the overarching RMF for climate and tailored to the business strategy, business model and balance sheet
• Having effective RMFs and/or quantitative risk appetite metrics for climate risk
• Appropriately factoring climate risk (including prudent assumptions and proxies) into modelling capabilities
  • For insurers, this will include climate risk management for underwriting purposes
  • Banks will have clear timelines for including climate factors in credit processes and a complete picture of counterparty exposures and transition plans
• Carrying out methodical analysis on whether to hold capital for climate change risk
• Including sufficient contextual information in capital methodologies to explain the analysis

Limitations in data mean that firms' use of scenario analysis is not yet sophisticated enough to be useful in decision-making. Where firms are using climate risk models, these are at an early stage of development. It is good practice for firms to recognise the uncertainty of scenario analysis, and reflect this in prudent assumptions, manual adjustments or sensitivity analysis.

The PRA identifies the following areas that require further work:

• Incorporating contextual information into scenario analysis
• Integrating scenario analysis output into ICAAPs and ORSAs
• Providing clarity on how appropriate the selected data and assumptions are to firms' own business vulnerabilities

Although progress has been promising, reflecting other work relating to SS3/19 as described above, firms need to continue to develop their disclosures. The PRA found that firms are generally making disclosures via their annual reports or through a standalone climate report, rather than through Pillar 3 reporting or Solvency and Financial Condition Reports (SFCRs). The PRA considers it effective practice to include disclosures in these “mainstream filings” and to provide consistent messaging and cross referencing across all reporting and disclosures. Where there is no mention of climate risk in Pillar 3 reporting or SFCRs, firms should be able to explain why the risk is considered immaterial.

All firms need more “robust, standardised climate-related data of sufficient coverage”. Most firms rely on third party data and, where data gaps are still identified, interim approaches using proxies are required. The most effective practices were observed where firms have identified their significant data gaps and are developing a strategic approach to close them, including balancing the use of third-party providers with developing short-, medium- and longer-term in-house capabilities. Use of appropriately conservative assumptions and proxies, internal documentation of estimates and disclosure of relevant material to users was also observed to be effective practice.

The letter is clear — every firm in scope of SS3/19 should by now be able to demonstrate how it is responding to the PRA's expectations and have measures in place that allow it to enhance approaches as industry practice develops and new data and tools become available. The PRA will continue to engage through regular supervisory activity and reviews and, where firms are not deemed to be making sufficient progress, they will be asked to provide a roadmap that clearly articulates how they intend to overcome the gaps. As set out in the 2021 Climate Adaptation Report (PDF 1.48 MB), supervisors will have recourse to the wider supervisory toolkit where the PRA feels that risks are not being adequately addressed.

Although the PRA does not set, interpret or enforce accounting standards, it notes that the application of these standards in relation to climate risk may have an impact on its statutory objectives. As approaches to accounting for climate risk evolve, firms will have greater clarity on the materiality of climate-related risks that may impact their balance sheets. For 2022 and beyond, the PRA expects financial reporting-related priorities to include enhancements to data and modelling capabilities, governance and controls, and disclosures. This may require the allocation of specific budget and resources for several years. Meanwhile, the PRA will continue to make use of external auditors' work in reviewing firms' climate risk assessments.