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Climate Risk Models

Volume 835: debated on Thursday 25 January 2024


Asked by

To ask His Majesty’s Government what assessment, if any, they have made of the accuracy of climate risk models used by (1) the Bank of England, (2) financial services firms, and (3) pension schemes.

The independent Bank of England’s climate biennial exploratory scenario builds on globally recognised scenarios from the Network for Greening the Financial System and represents an important milestone in assessing UK exposures to climate risk. However, we recognise that climate risk modelling is an evolving practice, and we support the Bank’s ongoing work to develop its modelling and supervision.

My Lords, the Bank of England’s job is the prudential risk management of the financial system, and it influences the conduct of firms and pension schemes, hence the concern when we learned that its scenarios concluded that it does not much matter whether temperatures rise by 1.5, 2 or 4 degrees: the effect on profits will still be relatively small. How will the Government ensure that the regulator properly oversees the risk to financial stability from more extreme weather and rapid changes in the use of energy?

The outcome of the CBES exercise shows that, if banks and insurers do not respond effectively, climate risk could cause a persistent and material drag on profitability: bank credit losses amounted to £110 billion over the late-action CBES scenario. But the Bank of England has always been clear that it was the first time it had done an exercise based on these scenarios, which came from 2021, as I am sure the noble Baroness knows. The NGFS has now refreshed its scenarios, publishing its latest group in November 2023; those will be used by the Bank of England and, indeed, by many other people in the financial system going forward.

My Lords, the best way to avoid financial collapse is to avoid climate tipping points. We welcome the progress to date on developing financial climate risk models, but this science is still in its infancy. We also welcome the Bank of England’s report of 13 March, updating its assessment of climate risks. The report notes the need to improve climate stress testing and scenario analysis. How will the Government support the development of these urgent tasks?

As the noble Lord is aware, our financial regulators are of course independent of government. However, the Government are clear in their annual letters to the various regulators that climate risk is a key part of all the elements they must consider when considering financial stability in the UK and, indeed, globally.

My Lords, the climate models currently used by the Bank of England and pension schemes have been shown by the Institute and Faculty of Actuaries, the Pensions Regulator, and even the coalition of central banks that developed them, to be deeply flawed, yet the Bank of England remains publicly committed to them. What are Ministers doing urgently to learn from academic and climate science, and to make recommendations to the Bank under Section 30B of the Bank of England Act to help it improve the financial modelling of climate risk? Also, what is my noble friend’s department doing to ensure that pension schemes invest more in our solar farms and wind farms, particularly, for example, via investment trust portfolios?

Goodness—that is a very wide-ranging question from my noble friend. I do not think it quite right to say that the Bank of England is committed to the scenarios it used back in 2021. For example, as my noble friend will have seen, two more scenarios were published fairly recently. The Government are not, for example, going to mandate a particular model or scenario for the pensions industry or indeed any part of it, because there are different scenarios out there. They are not forecasts but scenarios, and different groups will feel that different scenarios will come into play. Most pension schemes now have to follow the TCFD requirements, which came into force substantially in October 2022. That will really focus the pension schemes on their climate risks but also the climate opportunities.

My Lords, I need to mention my entry in the register of interests. Following the question from the noble Baroness, Lady Altmann, I urge the Minister to study the report from the Institute and Faculty of Actuaries, whose central conclusion was that commonly used climate models in financial services are underestimating risk. In particular, it says that the choice of assumptions is not widely understood and they pay insufficient attention to the possibility of overoptimistic scenarios for the future of climate change.

Of course, my officials and those who work for the independent regulators will look at all evidence, and one often finds that it is very conflicting. The challenges of the models used have been clearly established. There is a higher number of independent transmission channels than previously thought and a lack of historical data; and, of course, one has to anticipate a firm’s reaction to climate change over the longer term. All those things are being considered. This is an evolving science, as I think all noble Lords will agree. However, I go back to the NGFS, of which the Bank of England was a founding member: it consists of 134 central bankers and supervisors from around the world, who are all working together to improve the available scenarios.

My Lords, is my noble friend the Minister aware that the economic chapter of the IPCC report on climate change begins:

“For most economic sectors, the impact of climate change will be small relative to the impacts of other drivers … Changes in population, age, income, technology, relative prices, lifestyle, regulation, governance, and many other aspects of socioeconomic development will have an impact on the supply and demand of economic goods and services that is large relative to the impact of climate change”?

Why is the Bank of England fussing with this, rather than concentrating on the real problem of avoiding financial crises such as occurred in 2008?

No, I do not quite agree with my noble friend, because the Bank of England has a responsibility to look at all risks. He pointed out many risks that are not climate related. However, underlying all of this is that all those risks—and, indeed, climate risk—are interdependent. One cannot single out one at the expense of others; one has to consider them all in the round. That is why we make it clear when we correspond with the Bank of England and the independent regulators that climate risk is just one of the many risks to our financial system that need to be considered.

My Lords, the Government have made a series of important commitments relating to forest risk commodities. Those commitments, including in the Financial Services and Markets Act to carry out a review of the adequacy of financial regulation in tackling illegal deforestation, rely on the laying of regulations under the Environment Act. Can the noble Baroness tell us when those regulations will be laid and, once they are, how long the review will take?

I am well aware of the Government’s work on forest risk commodities, which is under way, as it falls within my portfolio. I cannot give the noble Lord any further timings at this moment, but suffice it to say that we are working on it.

My Lords, I think I heard the Minister say that the next round of the climate biennial exploratory scenarios needs to accommodate disruptive climate events in the 2020s and take account of the revised scientific consensus about the speed—that is the key word—with which adverse climatic events are being observed and new emerging evidence since the 2021 report. Will the Government ask the PRA to do this as a matter of urgency, with a real emphasis on urgency?

No, the Government will not ask the PRA—or indeed anybody else—to do that as a matter of urgency. It is up to those independent regulators to decide the next stage at which CBES may be rerun. However, an important learning experience came out of CBES, which was that many of the capabilities needed to be embedded in the system. It is pointless running a scenario if the underlying information and the risk scenarios and outcomes coming from firms have not been updated to reflect the new scenarios. The independent regulators are very seized of the issue. Obviously, CBES will be run in due course if the Bank of England decides that the results of its previous running have been embedded in the system.

My Lords, the noble Lord, Lord Lilley, said that the Bank of England has to take into account a variety of issues. Can the Minister say what work it is doing on AI? Is it in a better position than we are to see what is happening and the consequences?

My Lords, it is important to recognise what models do: they look at the real world in practice, try to explain it in theory, and then try to predict the future using past and, perhaps, future data. All models are flawed to a certain extent. Given the focus on other things apart from inflation, such as climate risk models, in my noble friend’s experience or opinion, does she think this distracts the Bank of England from one of its essential tasks, which is to focus on getting inflation below 2%?

The Bank of England has two major roles, as my noble friend will be aware: it is responsible for monetary policy but also for financial stability. Climate risk very much falls into the latter. However, he is absolutely right about models: there is probably not a single model in the world that is 100% accurate—they can never be. However, it is not about forecasts but about scenarios. It is about taking a range of possible outcomes and thinking about how firms would react to different scenarios. It is right that the Bank of England consider this; however, I know that it is very focused on getting inflation down.