Climate change regulation has shifted gears.
Momentum had been slow building up to that first hint back in 2018 that financial institutions would be expected to start reporting on climate change risk.
But since then, the pace at which the Bank of England and our regulators have driven the evolution of reporting requirements has accelerated.
Understanding climate change risk for lenders
In 2019, all financial institutions were told they must put climate change risk on a par with lending risk within their risk framework.
Only two years have passed, yet their efforts have already been scrutinised. Feedback in the form of the Bank’s Climate Biennial Exploratory Scenario (CBES), was issued in May.
Progressing at speed, the regulators’ urgency mirrors the urgency of the threat that climate change poses.
The six lenders involved, which account for 70% of mortgage lending, have made some impressive strides forward. Most keenly in the assessment of physical risks, such as flooding, to their back books.
But the clearest message CBES delivered is that more needs to be done.
Work to be done for lenders
Lenders must implement more developed climate change risk management systems that will allow them to reflect climate risk more accurately in their business decisions.
Physical risks, such as how frequent flooding will drive up insurance premiums and increase the strain on household finances, is being considered.
But the assessment of transition risks, a difficult exercise for any institution, has made minimal progress.
Transition risks for lenders
Transition risks emerge from our need to switch to a low carbon, greener economy as fast as possible.
The Bank wants lenders to assess how transition risks affect a borrowers’ ability to repay their mortgage and the value of their home. Such risks would include; a carbon tax, rising energy bills, or retrofitting costs to elevate EPC ratings.
Although there’s no evidence yet that house prices are being affected by climate change, lenders expect they will be in the future. But currently no processes exist to monitor the impact, or lack of it.
Meanwhile, a two-tier capability has been developing between those lenders with origination solutions that allow them to assess climate risk on new mortgage applications in real time – and those that remain blind to that risk.
Room for improvement
In short, the Bank’s summary of lenders’ performance so far is ‘good effort but can do better’.
It’s not a bad report card to be handed given the timeframe. It’s clear, however, that regulators want financial institutions to up their game.
An improvement in the accuracy, scope and depth of their reporting is needed.
Unusually for a regulatory paper, the Bank has given examples of best practice which should make lenders sit up and take notice.
It’s likely that these examples will become a standard for measurement of compliance with the Prudential Regulation Authority’s supervisory statement (SS3/19) that kicked things off in 2019.
But the improvement in data gathering and analysis shouldn’t just be to pass the PRA’s compliance measures. It should be improved to benefit borrowers too.
Lack of understanding
As yet, consumers are undeterred from buying a low-rated EPC home or a property at risk of flooding. That could be down to a lack of understanding about the immediate and future consequences of their decisions, rather than simply not caring.
Zoopla’s June Consumer Insights Survey found that 62% of consumers underestimated the cost savings of buying a highly-rated energy efficient home.
Living in an A or B rated new home, for example, offers annual savings of 52% compared to a lower-rated resale home. When asked, consumers guessed at around 20% or less or they had no idea at all.
And while the EPC rating itself is not a deal breaker for homebuyers, the outgoings attached to the property ranked as a high priority when choosing a home. The survey also highlighted
a poor understanding of what was required to upgrade homes to achieve a better rating.
Treating Customers Fairly
Lenders must treat their customers fairly.
So does that mean lenders have a duty of care to inform their customers of climate risks to their existing property or the one they plan to buy?
Should they explain the consequences of those risks and give advice on how to fix them?
It could be argued that sharing data they’ve collected which could influence or inform borrowers’ decisions falls under TCF principles.
If it emerges later down the line that a lender knew all along about certain risks to borrowers’ properties and said nothing, that exposes the lender to a different type of risk. A reputational one.
Benefits of lenders developing climate change risk management systems
It’s not just the Bank of England, regulators and lenders that will benefit from having more developed climate change risk management systems, it’s consumers too.
Financial institutions have a lot to work on and the clock is ticking. The severity of July’s heatwave and warnings of more extreme weather to come have made that clear.
But a lot has been achieved in just two years.
With the right support and tools that can harvest and harness climate change risk data, lenders can upgrade their report card from ‘must do better’ to ‘outstanding performance’.