Climate risk: An update to SS3/19 is on the horizon
What to expect for the banking industry
In April 2019 the PRA published its first climate supervisory statement, SS3/19: Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. Since its publication the banking industry has made progress towards meeting the PRA’s expectations. While the PRA has subsequently provided guidance and feedback (for example through Dear CEO letters), it has now been five years since SS3/19 was published. In January 2024 the Bank of England (BoE) confirmed that it was beginning work to update its April 2019 supervisory expectations to include, “among other things, identified effective practice and developments in wider regulatory thinking”.
We are expecting an evolution of the existing supervisory statement, rather than a revolution. The PRA said in one of its recent disclosures that “the revisions are expected to provide clarity to firms and build on the SS3/19 approach. The work is expected to consolidate previous Bank feedback to firms, such as through the Dear CEO letters, draw on Bank analysis since April 2019, and generally align with relevant international standards from the Basel Committee on Banking Supervision (BCBS)…”.
In this blog we set out our point of view on the different approaches the PRA could take in updating its 2019 supervisory statement. We also summarise our observations of industry progress against the four themes described in SS3/19, highlighting examples of where other regulators have provided more detailed guidance and examples.
Different approaches the PRA could take in updating SS3/19
We set out below three broad approaches we think the PRA could take, with Option 3 being the most likely in our view.
Option 1: An update that provides limited new information
The PRA could decide to adopt an approach that provides limited new information and guidance in its updated supervisory statement. For example, this could focus on consolidating other PRA feedback already provided to firms. We believe this to be an unlikely option given that so much time has passed since April 2019, and other regulators like the European Central Bank (ECB) and the BCBS have recently provided much more detailed guidance.
Furthermore, this type of update would be the least helpful to the industry. From speaking to different firms, the industry will benefit from the PRA providing more clarity and defining good practice. Firstly, this will better-enable firms to assess where to focus their efforts in improving their approach to climate risk management. Secondly, we believe that explicit guidance from the regulator will help firms secure resources to further invest in their capabilities. Finally, more clarity will also lead to more consistency across the industry.
Option 2: A prescriptive and detailed update
The industry is likely to find a more prescriptive and detailed update more helpful, for similar reasons as those set out above against Option 1. However, we do not think this type of update is likely given the PRA’s preference for applying a ‘judgement-based’ approach, where they would like firms to build their capabilities in a way that makes sense for their business. This has been particularly the case so far with PRA’s approach on climate risk. The PRA has avoided a ‘one size fits all’ prescriptive approach, preferring instead to provide guardrails in its guidance to firms, giving them flexibility to apply their own judgments to account for firm-specific processes, characteristics and considerations.
Option 3: A material update that focusses on addressing gaps in the industry’s capabilities
While the industry has made progress against existing expectations, gaps and fragmented approaches exist, as described in the next section. An update that is not overly prescriptive and that focusses on addressing these gaps and inconsistencies, while providing clear examples of what good looks like would be of most benefit to the industry. The PRA may consider asking the support of the Climate Financial Risk Forum (who reports to Sam Woods, CEO of the PRA) in sharing examples of best practice.
This type of approach is more aligned with the PRA’s usual approach to supervision and will also allow the PRA to better align with the ECB’s and BCBS’s guidance. For these reasons, we anticipate this option to be the most likely approach the PRA will take when updating SS3/19.
Our observations across the industry: Progress against SS3/19 to date
Since the release of SS3/19, the industry has made progress to manage the climate-related risks to which it is exposed. In its 2019 supervisory statement the PRA provided guidance and expectations against four themes: governance, risk management, scenario analysis, and disclosures and reporting. Based on our experience working with firms across the banking industry, we summarise our observations of progress against each theme:
- Governance: Many firms have built in-house expertise by creating climate-specific roles and providing firmwide training on climate-related risks. Firms increasingly link climate risk factors to personal objectives and/or senior renumeration targets. Many firms have set up a formal climate governance structure with a responsible Senior Management Function and dedicated committees.
An area in which further improvement is required is on the reporting of climate related management information. Some firms are still working on establishing the appropriate metrics and streamlining the integration of climate risks into their monitoring and reporting processes. Additional guidance and/or examples of good practice on this topic will be particularly helpful to the industry.
On monitoring and reporting, the BCBS provides expectations on data aggregation capabilities, internal reporting intervals and metrics that should be disclosed to stakeholders1 . Additional supervisory expectations from the PRA on this topic could lead to more robust and consistent reporting and monitoring. The BCBS expects firms to have processes in place to ensure that their data is accurate and reliable. In our experience, data quality can be difficult to verify for climate-related risks. For example, two data vendors can provide very different physical risk ratings for the same property due the different modelling approaches, highlighting the need for firms to assess both the accuracy and areas of weaknesses of each data provider.
A recent analysis performed by Deloitte highlights the lack of accuracy of metrics and data. The report states that nearly half of the UK’s largest companies have had to restate their climate and sustainability metrics this year, with 23% of restatements resulting from error correction.
- Risk Management: Embedding climate risk into risk management frameworks and policies across the lifecycle remains an evolving area for the industry. Progress has been made to consider climate and other environmental, social and governance (ESG) risks in underwriting, risk assessments, scenario analysis, stress testing and monitoring. More mature practises include the use of scenario analysis outputs to calibrate risk appetite metrics, integration into the ICAAP, strategic decision-making and financial planning.
Risk mitigation is one area where more progress needs to be made. While some firms have the capability to identify potential risks, we have observed a lack of clear action to mitigate the identified risks. BCBS provides clear examples2 of risk mitigation options and the industry will benefit from the PRA providing similar examples. The BCBS examples include amongst others, adjusting underwriting criteria, imposing loan restrictions and lower loan-to-value limits.
On the topic of incorporating climate risk into risk appetite, progress across the industry is fragmented. Comparing larger firms, all have started to integrate climate and/or ESG risks into risk appetite, but there is variation in the granularity of appropriate metrics, particularly in terms of quantitative metrics. Very limited progress has been made on climate risk appetite for smaller firms.
- Scenario Analysis: Most firms have developed some form of scenario analysis capability. Firms initially used regulatory scenarios, like those provided by the Bank of England in its 2021 Climate Biennial Exploratory Scenario (CBES). Larger firms have since shifted to using scenarios directly from institutions like the Network for Greening the Financial System (NGFS) or the International Energy Agency (IEA), while a small number of large firms use tailored scenarios that better reflect their own vulnerabilities. Firms continue to focus on improving their modelling capabilities for their more material portfolios, which typically include mortgage and corporate portfolios.
Commercial Real Estate (CRE) is a sector that has been in focus for regulators given the ongoing market downturn currently affecting this sector, driven by the high interest rate environment and lower demand. In one of its recent newsletters, the ECB focused on CRE collateral valuations, highlighting the good practices banks should adopt. The ECB highlights that firms should account for climate and environmental risks such as energy efficiency ratings, physical risks and the associated increased cost of insurance, and nature-related risks such as lack of fresh water supplies for regions impacted by this risk factor. The PRA may decide to align with this guidance given the heightened risks to this sector.
- Disclosures & Reporting: Most firms either include climate risks in their annual reports or disclose in a standalone climate/ESG report with a reference being made in Pillar 3 disclosures. There is however a range of practices in terms of the information being disclosed, particularly in terms of granularity and detail. More effective practices follow the structure and recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). These practises include identifying significant data gaps and outlining actions to address these gaps. They also include activities to further evolve firms’ disclosure and reporting framework.
The PRA has not previously provided any specific guidance on climate-related disclosures for Pillar 3 reporting. They may decide to align more with the European Banking Authority (EBA), who have published technical standards on Pillar 3 disclosures on ESG risks.
Additional uncertainties that face the banking industry
In respect of climate risk management, there are a few additional regulatory uncertainties which the PRA may address in its updated supervisory statement. Uncertainty about how firms with be supervised against the updated supervisory statement is one example. It is unclear whether deadlines will be set for implementing updated guidance, and whether enforcement measures, similar to those used by the ECB3 , will be applied. We do expect the PRA to maintain its view on proportionality with respect to its expectations, with smaller firms expected to be less advanced. Smaller firms would benefit from additional PRA guidance in terms of how proportionality will be applied. For example, whether the same implementation deadlines (if any) apply and highlighting differences in expectations for smaller and larger firms.
There is also uncertainty about when the PRA will ask firms to run another climate stress test, similar to its 2021 CBES. Also, the PRA’s focus to date has been on climate risk with no specific mention of nature-related risks. In one of our recent blogs, we discuss why nature risks are important and deserve more attention by the financial services industry, including regulators. As explained in that blog, the potential consequences of nature-related risks are significant. Therefore, to ensure the stability of the financial system we expect regulators to turn at least some of their attention to nature-related risks.
Summary
In summary, since the release of SS3/19, the industry has made progress to manage its climate-related risks across four themes: governance, risk management, scenario analysis and disclosures & reporting. However, based on our experience gaps and fragmented approaches exist. While the updates to the supervisory statement are not certain, we do expect closer alignment with the more recent guidance from other regulators. We also expect the PRA to take an approach that is not overly prescriptive and that focusses on addressing the gaps and inconsistencies in the industry.
Thank you to the following contributors: Ian Wilson, Simon Brennan and Alex Spooner.
__________________________________________________________
References
1Refer to Principle 7 set out in Principles for the effective management and supervision of climate-related financial risks (bis.org)
2Refer to Principle 8 set out in Principles for the effective management and supervision of climate-related financial risks (bis.org)
3Referring to progress against ECB guidance on climate-related and environmental risks, Frank Elderson said in December 2023 that “…we have told a number of banks to remedy the shortcoming by a certain date and, if they don’t comply, they will have to pay a penalty for every day the shortcoming remains unresolved.”
