UK regulators warn financial sector still failing to account for key climate risks

“There is a risk that banks and insurers take similar management actions around the same time, which could lead to volatility in financial markets and create risks to wider financial stability.”

by | November 1, 2021 | bobsguide

Several areas of the financial sector are still lacking sound strategies to mitigate key climate risks, UK regulators warned as they step up efforts to align the sector to the UK’s long-term net-zero commitments.   

The Financial Conduct Authority (FCA), the Prudential Regulation Authority (PRA), the Pension Regulator (TPR) and the Financial Reporting Council (FRC) released Climate Change Adaptation Reports on Thursday that identify the respective financial-sector areas that are prone to climate change risks that have not been properly tackled.

The FCA and PRA noted that mortgages are one of the areas where climate change risks prevention needs improvements  

While lenders seem to be taking climate-related risks into account “as they feed through into credit risk and a risk to the collateral held against loans,” the FCA warned they’re failing to reflect that in “significant, widespread changes […] in response to climate change outside their usual risk calculations.” 

One example would be taking into account the impact of “coastal erosion” and “flood risk” on housing valuations. Citing figures from a recent Bank of England’s discussion paper, the FCA pointed out that “around 10 percent of the value of mortgage exposures in England is on properties in flood-risk zones.” 

After hurricane Sandy hit the US in late 2012, for instance, properties in flooded areas of New York City suffered a 20 percent valuation drop – with current home values still hovering 10 percent lower than in neighbouring areas at present.  

“Banks need to be taking a strategic and organisation-wide approach to climate change, including both their mortgage and financing activities,” the watchdog said echoing similar evaluations by the PRA.  

The PRA, meanwhile, pointed out that interlinkages between the banking and the insurance sectors could also result in heightened climate risks.   

For example, the authority pointed out that “insurance contracts for property damage are typically written annually, but mortgages have an average term of 25-30 years.” 

This timeframe mismatch could pose significant risks for both the borrowers/policy holders and the lenders, it warned. 

“Should physical risks lead to more severe and frequent floods resulting in property damage, premiums may rise to unaffordable levels or coverage may reduce, leaving homeowners to bear the costs.”  

“A bank providing a mortgage against such homes could see loan-to-value ratios increase as the value of the home falls (either from actual property damage or a pricing in of increased risk of future property damage), resulting in losses for the bank. The homeowner may also suffer from a loss of income and have a higher probability of default,” it added.   

A similar situation could happen for firms that hold business interruption insurance that protects them from physical losses, the regulator pointed out.   

“If physical risks from climate change increases, the resulting repricing could lead to insurance protection gaps. Banks’ lending to these corporates may therefore face a higher probability of default if these corporates are less protected against business interruption from physical events,” the report said.   

Overall, the report highlighted, banks and insurers’ adjustment to growing climate change risks could prompt some key potential headwinds. 

“There is a risk that banks and insurers take similar management actions around the same time, which could lead to volatility in financial markets and create risks to wider financial stability.”  

Pension and Retirement incomes  

Meanwhile, progress by the UK pension sector towards integrating climate risk received mixed reviews, with Charles Counsell, TPR’s chief executive, saying the segment “still has much work to do to build resilience and assess climate-related risks and opportunities.” 

TPR found that only 43 percent of defined contribution (DC) pension schemes took into account climate change when formulating their investment strategies last year.   

“The main reason given for not considering climate change was that it was not felt to be relevant to their scheme (mentioned by 21 percent). However, a similar proportion (19 percent) stated that they were planning to review whether they should start taking account of climate change,” TPR said in the report.   

Defined Benefit (DB) schemes did not perform much better than DC in the report findings, with just 51 percent allocating time or resource to assessing any financial risks and opportunities associated with climate change.  

However, both TPR – which regulates occupational schemes overseen by trustees – and the FCA – which regulates workplace and non-workplace schemes that are provided by insurers and Self-Invested Personal Pension (SIPP) operators – argued that pension schemes could see a positive impact from considering climate change in their investment and scheme governance.  

The FCA noted that while pensions of all kinds suffer from relatively low consumer engagement, recent changes in the sector have the potential to better align outcomes with climate change risks and opportunities.   

“This picture is still evolving, and there will no doubt be further changes as a result of the industry’s own initiatives, as well as government and regulatory action.” 

It further pointed out that if pension funds do not take into account long term physical and transition climate risks, “there is a risk that pensions will remain invested in assets which decline in value when climate risks crystallise.”   

“Where pension providers integrate climate risk in their investment strategies, it can help ensure better long-term outcomes for consumers by protecting pension pots from being negatively affected by climate change.” the report said.   

Increased risk of greenwashing in retail investment  

Once again, the risk of greenwashing was portrayed as a roadblock in UK’s long-term net zero commitments by the regulators.  

The FCA noted that retail investment is another area where the financial sector needed to work harder on preventing climate change risks, arguing that the market for ESG product has so far been driven by investor appetite, and the sector needed to follow through with more effective and transparent offerings. 

“The sustainable investment sector has been experiencing an unprecedented demand for ESG products. This reflects a market that is adapting at pace to climate-related changes – albeit driven by consumers’ needs and preferences more than direct physical events.  

“But it nevertheless raises several issues about how the industry and other stakeholders adapt, which revolve primarily around transparency and disclosures,” the report said.  

“The risk of greenwashing may be particularly relevant for retail investors in the fund management sector,” the FCA said, reiterating concerns on the quality of ESG fund applications reflected earlier in the year.   

To counter this risk, the FCA emphasised the importance of accurate sustainable reporting for funds with ESG-related claims, saying it is working with the government to oversee the delivery of a ‘Green Taxonomy’ – a common framework setting the bar for investments that can be defined as environmentally sustainable. The move follows the roadmap recently published by the government for phasing in sustainability disclosure requirements for both the financial and the corporate sector.  

ESAs issue final standards for SFRD and EU Taxonomy rulebook 

Along similar lines, the three European Supervisory Authorities (ESAs) sent final Regulatory Technical Standards (RTS) to the European Commission last week to establish a single rulebook for sustainability disclosures under both the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation. 

The RTS, which may be adopted by the Commission within the next three months, aim to broaden information available to the end investors, providing them with comparable data across financial products that are linked to environmentally sustainable economic activities. 

This will include “pre-contractual and periodic disclosures that identify the environmental objectives to which the product contributes and show how and to what extent the product’s investments are aligned with the EU Taxonomy.” 

To achieve that, firms will be required to post graphs showing the Taxonomy alignment of the product based on a specified calculation methodology, and to provide either an auditor’s assurance or a third-party review testifying that “the economic activities funded by the product that qualify as environmentally sustainable are compliant with the detailed criteria of the Taxonomy Regulation.” 

Additional reporting by Anna Brunetti

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