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Climate change and the financial sector - New trends in the financial sector

The impact of climate change on the objectives of central banks

By Fisher Paul - Deputy Head of the Prudential Regulatory Authority and Executive Director, Bank of England

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Climate change is a slow-moving process relative to many other public policy issues. But financial markets are forward-looking, so the financial stability impacts could be felt at any time – and indeed may already be playing out as some investors change their portfolios to reflect sustainability issues.

Central banks across the globe are tasked with promoting monetary and financial stability and are quite used to thinking about the lags between policy action and effect. The Bank of England’s work to date has focussed on the insurance industry, with publication in 2015 of the PRA’s report on ‘The Impact of Climate Change on the UK Insurance Sector’.

General insurance provides protection against damage and loss from a wide range of causes. These include not only the impact of extreme weather, such as storms and floods, but also liability risks, such as those from asbestos, where compensation can be sought a long time after the event. Life insurance policies are typically linked to mortality risks and long term savings, such as annuities and endowments, which can cover multiple decades. On these timescales, the challenges of climate change become very real and significant.

The financial stability impacts could be felt at any time.

The PRA’s report provides a template for analysing climate change risks to the financial sector. It breaks them down into 3 main areas:

i) Physical Risks arising from actual changes in climate. These include increased losses arising from more extreme events and changes in correlations. They are clearly relevant to general insurers but could also have unanticipated effects on life insurers, such as impacting investments in property.

ii) Transition Risks arising from the move towards a lower carbon economy. In particular, policy changes could lead to sharp changes in the relative value of some financial assets. This poses a bigger risk to those holding longer-term assets such as the life insurers (and other asset managers).

iii) Liability Risks which insurers may have underwritten and which could crystallise as those who suffer loss from climate change turn to the courts for compensation. Both corporate and public bodies may be challenged. The extent of insurers’ liabilities may not be easily evaluated where general protection has been written.

The PRA’s report is already being used to inform supervisory conversations in the UK and has been a path-breaking exercise for the involvement of central banks on climate change. Alongside insurance, the Bank’s work now includes three further themes. First, mapping out the wider impact of climate change on its responsibilities. Second, contributing to the Financial Stability Board’s industry-led task force on climate related financial disclosures. Third, co-chairing a G20 Green Finance Study Group, alongside China, to analyse options for enhancing the ability of the financial system to mobilize private green investment. All of these initiatives are expected to make progress in 2016, building on the momentum of 2015.