Key elements of the 2021 Biennial Exploratory Scenario: Financial risks from climate change

The 2021 Biennial Exploratory Scenario will explore the resilience of the UK financial system to the physical and transition risks associated with different climate pathways.
Published on 08 June 2021

1: Executive summary

The Bank runs regular stress tests to help assess the resilience of the UK financial system and individual institutions. There are two types of exercise within the Bank’s concurrent stress-testing framework for banks and building societies (hereafter ‘banks’): annual solvency stress tests; and biennial exploratory scenarios. The Bank also runs stress tests on a periodic basis for a number of insurance firms.

Running biennial exploratory scenarios allows policymakers to probe the resilience of the UK financial system to a wide range of risks, and is a tool to enhance participants’ strategic thinking on how to manage those risks. The 2021 exercise explores the resilience of the largest UK banks and insurers to the physical and transition risks associated with climate change.

The desired outcomes of the 2021 Climate Biennial Exploratory Scenario (CBES) are to:

  • Size the financial exposures of participants and the financial system more broadly to climate-related risks.
  • Understand the challenges to participants’ business models from these risks; and gauge their likely responses and the implications for the provision of financial services.
  • Assist participants in enhancing their management of climate-related financial risks. This includes engaging counterparties to understand their vulnerability to climate change.

The Bank intends for the CBES to be a learning exercise. Expertise in modelling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the Bank and CBES participants.

The CBES will explore the vulnerability of current business models to future climate policy pathways and the associated changes in global warming. In doing so, it will help to identify the potential risks posed to those business models over time. To do this, participants will measure the impact of the scenarios on their end-2020 balance sheets, which represents a proxy for their current business models. For banks, the CBES focuses on the credit risk associated with the banking book, with an emphasis on detailed analysis of risks to large corporate counterparties. For insurers, the CBES will focus on changes in Invested Assets (and Reinsurance Recoverables) and Insurance Liabilities (including accepted Reinsurance).

The CBES will also explore how firms intend to adapt their business models over time, in light of climate changes. The exercise also covers the management actions participants would anticipate taking in the published scenarios; as well as participants’ present and future planned approaches to managing climate risk.

The exercise will not be used by the Bank to set capital requirements, and individual participants’ projected losses will not be tied directly to actions participants are required to take. Instead, participants’ submissions may inform the Financial Policy Committee’s (FPC’s) approach to system-wide policy issues; the Prudential Regulation Authority’s (PRA’s) approach to supervisory policy; and guide further work between participants and supervisors to address any issues highlighted.

The CBES uses three scenarios to explore the two key risks from climate change: the risks that arise as the economy moves from a carbon-intensive one to net zero emissions – transition risks; and risks associated with the higher global temperatures likely to result from taking no further policy action – physical risks. All three scenarios explore both transition and physical risks, to a different degree.

The CBES scenarios are not forecasts of the most likely future outcomes. Instead, the scenarios are plausible representations of what might happen based on different future paths of governments’ climate policies (policies aimed at limiting the rise in global temperature). Each scenario is assumed to take place over the period 2021–50.

The exercise considers two routes to net zero greenhouse gas emissions: an Early Action scenario and a Late Action scenario (Table 1.A). These scenarios primarily explore transition risks from climate change:

  • Early Action: the transition to a net-zero economy starts in 2021 so carbon taxes and other policies intensify relatively gradually over the scenario horizon. Global carbon dioxide emissions are reduced to net-zero by around 2050. Global warming is limited to 1.8°C by the end of the scenario (2050) relative to pre-industrial levels. Some sectors are more adversely affected by the transition than others, but the overall impact on GDP growth is muted, particularly in the latter half of the scenario once a significant portion of the required transition has occurred and the productivity benefits of green technology investments begin to be realised.
  • Late Action: The implementation of policy to drive the transition is delayed until 2031 and is then more sudden and disorderly. Global warming is limited to 1.8°C by the end of the scenario (2050) relative to pre-industrial levels. The more compressed nature of the reduction in emissions results in material short-term macroeconomic disruption. This affects the whole economy but is particularly concentrated in carbon-intensive sectors. Output contracts sharply in the UK and international economies. The rapid sectoral adjustment associated with the sharp fall in GDP reduces employment and leads to some businesses and households not being able to make full use of their assets, with knock-on consequences for demand and spending. Risk premia rise across multiple financial markets.

The No Additional Action scenario primarily explores physical risks from climate change. Here, there are no new climate policies introduced beyond those already implemented. The absence of transition policies leads to a growing concentration of greenhouse gas emissions in the atmosphere and, as a result, global temperature levels continue to increase, reaching 3.3°C relative to pre-industrial levels by the end of the scenario.footnote [1] This leads to chronic changes in precipitation, ecosystems and sea-level. There is also a rise in the frequency and severity of extreme weather events such as heatwaves, droughts, wildfires, tropical cyclones and flooding. There are permanent impacts on living and working conditions, buildings and infrastructure. UK and global GDP growth is permanently lower and macroeconomic uncertainty increases. Changes in physical hazards are unevenly distributed with tropical and subtropical regions affected more severely. Many of the impacts from physical risks are expected to become more severe later in the 21st century and some will become irreversible. So the headwinds facing the economy would be expected to increase further into the future.

The CBES scenario specification builds upon a subset of the Network for Greening the Financial System (NGFS) climate scenarios. NGFS climate scenarios aim to provide central banks and supervisors with a common starting point for analysing climate risks under different future pathways. They are produced in partnership with leading climate scientists, leveraging climate-economy models that have been widely used to inform policymakers, and have been used in key reports.footnote [2]

The Bank expects to publish CBES results in May 2022, following two rounds of participants’ submissions. Results might be published sooner if the Bank decides not to ask for the second round of submissions.

Figure 1.A: The 2021 Biennial Exploratory Scenario explores transition and physical risks from climate change

Summary of impacts in the CBES scenarios

Impact on UK carbon prices, sea-level, output and global temperature shown.  Illustrates that transition risk is key in the early and late action scenarios and physical risk key under the no additional action.

Footnotes

  • Sources: Met Office, Network for Greening the Financial System and Bank calculations.

2: Background

2.1: Biennial Exploratory Scenario

The Bank runs regular stress tests to help assess the resilience of the UK financial system and individual institutions. There are two types of exercise within the Bank’s concurrent stress-testing framework for banks and building societies: the annual solvency scenario and the biennial exploratory scenario (BES). The Bank also runs stress tests on a periodic basis for a number of insurance firms.

The BES allows policymakers to probe the resilience of the financial system to a wider range of risks than those closely linked to the financial cycle, and is a tool to enhance participants’ strategic thinking on how to manage different risks.

The 2021 exercise aims to test the resilience of the current business models of the largest banks and insurers, and the financial system to the physical and transition risks from climate change.

The 2021 BES includes both banks and insurers for the first time. By testing both banks and insurers using the same scenarios, this Climate Biennial Exploratory Scenario (CBES) will allow the Bank to explore the risks presented by climate change across the financial system more fully.

The CBES explores three different climate policy scenarios, which generate a range of possible future outcomes for global temperatures and the economy, each spanning 30 years.

Box A sets out differences between the CBES and the Bank’s annual solvency stress tests.

2.2: The Bank’s response to the financial risks from climate change

There are two sources of financial risks from climate change: the risks associated with actions to reduce greenhouse gas emissions – transition risks; and risks associated with the higher global temperatures likely to result from taking no further policy action – physical risks.

The financial risks from climate change affect the safety and soundness of firms the Bank regulates and the stability of the wider financial system that it oversees. Climate-related financial risks therefore have a direct impact on the delivery of the Bank’s macroprudential and microprudential policy objectives, as set out in relevant legislation and the respective remit and recommendation letters (remit letters) from Government to the Financial Policy Committee and Prudential Regulation Committee (PRC).

In addition, while the primary levers for driving an orderly economy-wide transition to net-zero emissions rest with governments (eg climate policy) and industry (eg innovation and investments), the Bank has a key supporting role to play as the Government develops and sets out its plans. This role was highlighted in the recent changes to the policy committees’ remit letters. The CBES contributes to this role by helping to assess the financial impacts of different possible temperature pathways and climate policy actions.

The CBES is one of the Bank’s workstreams aiming to ensure the financial system is resilient to climate-related financial risks. More detail on the Bank’s wider approach to managing climate-related risks can be found on its climate change webpage.

2.3: CBES objectives

The desired outcomes of the CBES are to:

  • Size the financial exposures of participants and the financial system more broadly to climate‑related risks.
  • Understand the challenges to participants’ business models from these risks; and gauge their likely responses and the implications for the provision of financial services. This includes investigating the interdependency between insurers and banks (such as the impact of potential changes in insurance provision on banks’ credit risk exposures and the impact of potential changes in bank lending on the value of insurers’ asset holdings).
  • Assist participants in enhancing their management of climate‑related financial risks, consistent with expectations set out in Supervisory Statement 3/19 and the Dear CEO letter dated 1 July 2020. This includes embedding these risks in business as usual risk management, engaging counterparties to understand their vulnerability to climate change, and encouraging boards to take a strategic, long‑term approach to managing these risks.

The Bank intends for the CBES to be a learning exercise. Expertise in modelling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the Bank and CBES participants. The CBES draws upon lessons learnt from the climate scenarios in the 2019 Insurance Stress Test and will help the Bank develop its approach to climate scenario analysis, both domestically and through international groups like: the Network for Greening the Financial System (NGFS); the International Association of Insurance Supervisors; the Sustainable Insurance Forum; and the Financial Stability Board. The results will enhance the Bank’s understanding of the financial stability implications of climate change and supplement supervisors’ knowledge of participants’ governance and climate‑related risk management.

The exercise will not be used by the Bank to set capital requirements. And individual participants’ projected losses will not be tied directly to actions participants are required to take. Instead, participants’ submissions may inform the FPC’s approach to system‑wide policy issues, the PRA’s approach to supervisory policy and guide further work between participants and supervisors to address any issues highlighted.

3: Key features of the CBES exercise

The CBES scenarios and guidance for participants have been calibrated and produced by Bank staff, under the guidance of the FPC and PRC.

3.1: Participation

Table 3.A lists the CBES participants. They are to report on a group consolidated basis unless otherwise stated.

Table 3.A: The 2021 Climate Biennial Exploratory Scenario explores the resilience of the largest UK banks and insurers to risks from climate change

CBES participation and coverage

Large UK banking groups and building societies

Large UK life insurers

Large UK general insurers

Participation:

  • Barclays
  • HSBC
  • Lloyds Banking Group
  • Nationwide Building Society
  • NatWest Group
  • Santander UK
  • Standard Chartered
  • Aviva
  • Legal & General
  • M&G
  • Phoenix
  • Scottish Widows
  • AIG (UK entities only)
  • Allianz Holdings plc (UK entities only)
  • Aviva
  • AXA (UK entities only)
  • Direct Line
  • RSA (UK entities only)

Society of Lloyd’s
(Ten selected Syndicates)

Coverage:

Around 70% of UK bank lending to UK households and businesses.

Around 65% of the UK life insurance market by asset size.

A range of business models (annuities, with-profits, unit-linked).

Around 60% of the UK general insurance market by Gross Written Premium.

Ten selected Syndicates account for around 40% of the Society of Lloyd’s property and liability insurance market by premium.

Society of Lloyd’s will estimate the results for the entire market based on their results.

3.2: Focus

The CBES will explore the vulnerability of participants’ current business models to future climate-policy pathways and associated degrees of global warming. In doing so, it will help to identify the potential risks posed to those business models over time. To do this, participants will measure the impact of the scenarios on their end-2020 balance sheets, which represents a proxy for their current business models. In general, the nominal size and composition of balance sheets are assumed to be fixed, and will be updated to account for mitigation and adaptation plans of counterparties only if they are already under way, and are highly likely to be completed.

For banks, the CBES focuses on the credit risk associated with the banking book, with an emphasis on detailed analysis of risks to large corporate counterparties. A key metric of that risk will be the cumulative total of provisions against credit-impaired loans at various points in the scenarios. Traded risk and non-traded market risk will be out of scope.

For insurers, the CBES will focus on changes in Invested Assets (and Reinsurance Recoverables), and Insurance Liabilities (including accepted Reinsurance) assuming an instantaneous shock. This means that the stress brings forward the future climatic environment to today’s balance sheet, with no allowance for changes in future premiums, asset allocation, expenses, reinsurance programmes and other future changes in participants’ business models.

In addition to sizing the financial risks from climate change, the exercise will explore how participants might change their business models to mitigate risk in the scenarios – their ‘management actions’. The CBES is also designed to enable the Bank to assess participants’ present and future planned approaches to managing climate risks. It will also explore risks from climate litigation. Some of this information will be captured via a questionnaire to be completed by participants. Details on data requirements and methodological approach are set out in guidance for participants.

The Bank does not intend to disclose the results of individual firms. This reflects the exploratory nature of the exercise. Instead, the Bank anticipates disclosing system‑level results of the financial sector’s resilience to climate change, including highlighting the main sources of loss by sector and geography. It may also publish ranges of results across participants.

3.3: Timelines

The Bank expects to publish aggregated CBES results in May 2022.

Before the final results are published, the Bank expects to run a second round of the exercise, which would launch around the end of January 2022. A decision on the form and content of this second round will be based on analysis of participants’ initial submissions. The second round could focus, for example, on exploring particular potential interactions between participants’ responses. Should the Bank decide not to run a second round of the exercise, CBES results will be published before May 2022.

3.4: Overview of the scenarios

3.4.1: Conditioning assumptions

All climate scenarios are subject to significant uncertainty, both from estimating the precise extent of transition and physical risks resulting from the conditioning assumptions, and from estimating the impact of these risks on macroeconomic and financial variables.footnote [3]

The CBES scenarios are not forecasts of the most likely future outcomes. Instead, the scenarios are plausible representations of what might happen based on different future paths of government climate policy (policy aimed at limiting the rise in global temperature).

All three scenarios explore both transition and physical risks, to a different degree.

The CBES considers two pathways to net zero greenhouse gas emissions: an Early Action scenario and a Late Action scenario. These scenarios primarily explore transition risks from climate change:

  • Early Action: the transition to a net-zero emissions economy starts in 2021 so carbon taxes and other policies intensify relatively gradually over the scenario horizon. Global carbon dioxide emissions (and all greenhouse gas emissions in the UK) drop to net-zero around 2050.
  • Late Action: the transition is delayed until 2031, at which point there is a sudden increase in the intensity of climate policy. In the UK, greenhouse gas emissions are successfully reduced to net-zero around 2050, but the transition required to achieve that is more abrupt and therefore disorderly.

The No Additional Action scenario primarily explores physical risks from climate change. In this scenario, no new climate policies are introduced beyond those already implemented prior to 2021.

The CBES scenario variable paths are available at the Bank Stress testing website.

The CBES scenarios are based on a subset of NGFS climate scenarios.footnote [4] Building on the NGFS climate scenarios ensures that the CBES scenarios are grounded in a consistent set of pathways for physical climate change, the energy system, land-use and the wider economy. Specifically, the CBES scenarios take the NGFS Net Zero 2050, Delayed Transition and Current Policies scenarios as a starting point. The Bank has expanded on the NGFS scenarios by including additional risk transmission channels and adding additional variables (working with climate scientists, academics and industry experts).footnote [5] As a result, the Climate BES scenarios are not identical to those produced by the NGFS, but they are consistent across many variables.

An important indicator of the level of transition risks in these scenarios is the carbon price. Transitioning away from fossil fuels and carbon-intensive modes of production requires significant investment in low-carbon alternatives in all sectors of the economy. Policymakers can induce this transition by increasing the implicit cost of emissions. The carbon price can be thought of as a summary of these policies, and so is closely linked to the extent of transition risk.

Throughout this document, the term carbon price is used to refer to a shadow price of all greenhouse gas emissions, ie the marginal abatement cost of an incremental tonne of emissions. The higher shadow price of emissions indicates a more stringent transition policy. This is a simplification, intended to capture a range of different transition policies. In reality, governments can adopt a mix of policies to reduce greenhouse gas emissions, which may include, for example, carbon taxes, cap-and-trade schemes, green subsidies and environmental regulations.

Differences in carbon prices across countries in the CBES scenarios reflect:

  • Different opportunities for reducing emissions. For example, the amount of land and resources available for deployment of carbon dioxide removal technologies such as bioenergy with carbon capture and storage.
  • Sectoral make-up of the economies, given some sectors are more reliant on carbon than others.
  • The costs of reducing emissions in different regions. For example, the relative price of emissions-neutral electricity.

In the Early Action scenario, carbon prices increase from roughly US$30 per tonne of carbon dioxide-equivalent today, to just under US$900 by 2050 in the UK and EU (abstracting from general inflation over the time period).footnote [6] In the Late Action scenario, carbon prices remain at US$30 until 2030, and then rise steeply to over US$1,000 in 2050. In the No Additional Action scenario, carbon prices do not rise (Chart 3.1).footnote [7]

Chart 3.1: In the Early and Late Action scenarios, stringent climate policies are associated with a fall in carbon emissions to net zero in the UK and the EU; but in the No Additional Action scenario emissions fall only moderately (a)(b)

Lines show different paths for carbon prices and emissions across the three scenarios.

Footnotes

  • Sources: Network for Greening the Financial System and Bank calculations.
  • (a) Carbon price depicts a shadow price of greenhouse gas emissions, ie the marginal abatement cost of an incremental tonne of emissions. This is a simplification, intended to capture a range of different policies to reduce greenhouse gas emissions, which may include, for example, carbon taxes, cap-and-trade schemes, green subsidies and environmental regulations.
  • (b) As the No Additional Action scenario is calibrated based on temperature outcomes that might be observed in the period 2050–80, emissions over that later time period are also relevant. The calibration of No Additional Action scenario is consistent with combined UK and EU net carbon dioxide emissions of 922 megatonnes per year by 2080.

Changes in emissions, and the atmospheric concentration of greenhouse gases, translate through to changes in global mean temperatures. Global mean temperatures have already increased by around 1.1°C from pre-industrial levels.footnote [8] In the Early and Late Action scenarios, carbon dioxide emissions globally (and greenhouse gas emissions in the UK) reach net-zero. Because of the significant lags between emissions and warming levels, temperatures continue to rise, reaching a global warming level of 1.8°C by this point (Table 3.B). The degree of warming is then projected to fall slightly from its peak in these scenarios to 1.6°C by the end of the century, due to actions (eg changes in land-use) that help to remove some greenhouse gases from the atmosphere.

Taking policy action sooner in the Early Action Scenario would mean that there was more chance of a lower peak temperature than in the Late Action Scenario.footnote [9] As a prudent and simplifying assumption, however, the warming level incorporated is the same in the Early and Late Action scenarios. That means different degrees of transition risks alone will drive differences in the impact of these two scenarios.

In the No Additional Action scenario, global warming relative to pre-industrial times reaches 3.3°C by 2050. Climate scientists’ projections conditioned on no further policy action suggest, however, that temperature increases as significant as these would only be likely to occur later in the century. The shifting forward in time of these more severe temperature rises – and associated physical risks – is deliberate, as it will allow the Bank to explore the impact of these more extreme risks. Specifically, the calibration is based on climate outcomes that could materialise between 2050 and 2080 in the absence of further policy action, consistent with warming reaching 4.1°C by the end of the century.

The temperature pathway used in this scenario is based on the 90th percentile of the projected distribution of warming outcomes conditional on further policy inaction. The Bank has made this calibration choice in recognition of the large degree of uncertainty surrounding temperature pathways, as well as the modelling uncertainty related to physical risks, including the difficulty of modelling potential developments such as conflict and mass migration, which do not feature in the calibration.

Table 3.B: Global warming levels reach 3.3˚C by the end of the No Additional Action scenario; and 1.8 ˚C in the Early and Late Action scenarios

Change in global warming levels relative to pre-industrial times

(˚C)

Year 0

Year 10

Year 30

Early and Late Action scenarios (a)

1.1

1.4

1.8

No Additional Action scenario (b)

1.1

2.5

3.3

Footnotes

  • Sources: Network for Greening the Financial System and Bank calculations.
  • (a) Taking policy action sooner in the Early Action Scenario would mean that there was more chance of a lower peak temperature than in the Late Action Scenario. As a prudent and simplifying assumption, however, the warming level incorporated is the same in the Early and Late Action scenarios. That means different degrees of transition risks alone will drive differences in the impact of these two scenarios.
  • (b) Related to the fact that the physical risks element of the No Additional Action scenario is calibrated based on the physical risks that might be expected to materialise in the period from 2050 to 2080 if no further policy action were taken, it is assumed that the shift to 2.3°C warming occurs on Day 1 of the No Additional Action scenario. Warming levels then increase to 3.3oC over the course of the scenario.

The amount of carbon sequestration (removing carbon from the atmosphere and its long-term storage) is a key assumption in the CBES scenarios.footnote [10] At present, carbon sequestration technologies face challenges in terms of investment and deployment. Reflecting that, the Early Action scenario assumes only a moderate level of sequestration can be achieved by private and public investment in this area. Both the Late Action and No Additional Action scenarios assume low levels of carbon sequestration, in the absence of timely and sizable investments in carbon sequestration technologies.

3.4.2: Summary of risks and impacts

Transition risks affect the profitability of businesses and wealth of households. They also affect the broader economy through investment, productivity and relative price channels. This is particularly the case if the transition forces businesses and households to stop using some of their assets before the end of their productive lives, leading to an increase in stranded assets.

In the Early Action scenario, the transition starts in 2021 so carbon prices (ie carbon taxes and other policies incentivising the reduction of emissions) increase relatively gradually over the scenario horizon, reaching around US$900 (abstracting from general inflation over the time periodfootnote [11]) in the UK by the end of the scenario (Figure 3.A). As in the NGFS Net Zero 2050 scenario, the reduction in greenhouse gas emissions occurs gradually across multiple sectors. This is achieved by decarbonising energy supply, accelerating electrification and switching to low-carbon fuels in industry, transport and buildings, as well as some carbon sequestration.

In the Late Action scenario, the transition is delayed for ten years. There could be many potential triggers for such a shift. For example, a cumulative increase in significant climate-related events could materially strengthen the impetus for government action worldwide. Because the transition is delayed for ten years, it has to happen faster than in the Early Action scenario to ensure carbon dioxide emissions drop to net-zero.footnote [12] It is also disorderly, requiring unexpected and urgent changes in the behaviour of households and businesses. A sharp rise in carbon prices leads businesses to abandon otherwise productive assets, reduce employment in emissions-intensive activities, and invest in green alternatives. This leads to a short-term drop in output as businesses adjust their business models. Because the supply of energy is fixed in the short-to-medium term, this drives inflationary pressures in raw materials, goods and services.

The No Additional Action has little transition risk, but the level of warming leads to material changes in physical perils. Physical risks affect the economy via:

  • Acute risks from the increasing frequency and severity of extreme weather events such as heatwaves, droughts, tropical cyclones and floods.
  • Chronic risksfootnote [13] (from increased average temperatures, sea level rise and higher precipitation). For example, sea level rises by 0.4m in the UK by the end of the scenario.

Both sources of risk can impact living and working conditions, buildings, infrastructure and agriculture. This will affect all households and businesses in the economy, albeit to a varying degree depending on their exposure, vulnerability and ability to adapt.

The CBES will help the Bank to analyse the potential impact of transition scenario variables (eg carbon prices) and physical scenario variables (eg sea level rises) on losses faced by participants. These direct climate variables are expected to play an important role in determining the total impact of the scenarios. Macroeconomic scenario variables (eg GDP) will also have some impact, especially in the Late Action scenario.

The macroeconomic impacts of transition risks is modest at an aggregate level in the Early Action scenario, as the effects of higher carbon prices and energy costs are mostly offset by energy efficiency improvements and distributional effects of these policy measures.

GDP growth is more severely affected in the Late Action scenario. This is due to a rapid sectoral adjustment affecting the labour market and leading to stranded assets, with knock-on consequences for demand and spending, and a rise in risk premia on many assets.

In the No Additional Action scenario, physical risks lead to a material and permanent reduction in the GDP growth rate. Many of the impacts from physical risks are expected to crystallise or become more severe in a non-linear way towards the end of the 21st century, so the negative impact on GDP associated with the No Additional Action scenario would be expected to increase with time, well beyond the scenario horizon.footnote [14]

The macroeconomic impacts from physical risks would be even higher if societal changes like migration and conflict were to rise, although these are out of scope of the NGFS and CBES scenarios.

Figure 3.A: The 2021 Biennial Exploratory Scenario explores transition and physical risks from climate change

Summary of impacts in the CBES scenarios

Impact on UK carbon prices, sea-level, output and global temperature shown.  Illustrates that transition risk is key in the early and late action scenarios and physical risk key under the no additional action scenario.

Footnotes

  • Sources: Met Office, Network for Greening the Financial System and Bank calculations.

Box A: Distinct features of the 2021 Climate Biennial Exploratory Scenario

There are several features that make the 2021 CBES distinct from the Bank’s annual solvency stress tests.

  • Wider scope: In addition to macrofinancial variables, the scenarios include direct climate variables to explore physical and transition risks from climate change.
  • Wider participation: CBES tests both banks and insurers using the same scenarios.
  • Multiple scenarios with long horizon: CBES uses three scenarios, each spanning 30 years – much longer than in typical stress tests.
  • Exploratory exercise: the Bank intends for the CBES to be an exploratory exercise as opposed to a stress test. Expertise in modelling climate-related risks is in its infancy, so this exercise will develop the capabilities of both the Bank and CBES participants.
  • Novel modelling approaches: participants will use novel modelling approaches to estimate the impact of climate change on their current exposures. They will conduct very granular analysis (by geography, sector and/or counterparty).
  • Not informing capital requirements: the exercise will not be used by the Bank to inform capital requirements. Instead, it will inform the FPC’s approach to system‑wide policy issues, the PRA’s approach to supervisory policy, and guide further work between participants and supervisors to address any issues highlighted.
  • A second round of submissions: the Bank expects to run a second round of the exercise, which could focus, for example, on exploring interactions between participants’ responses.

4: Detailed description of the CBES scenarios

4.1: Transition risks

4.1.1: Transition policies and the impact on emissions

In the Early Action scenario, climate policies are enacted in 2021. As a result, carbon taxes and other policies intensify relatively gradually over the scenario horizon. As in the NGFS Net Zero 2050 scenario, global carbon dioxide emissions drop to net-zero before 2050 (Chart 3.1). The reduction in emissions occurs gradually across multiple sectors. This is achieved by: decarbonising the energy supply; accelerating electrification; switching to low-carbon fuels in industry, transport and buildings; and reducing agricultural emissions. Carbon sequestration also increases modestly. Some jurisdictions such as the UK, US, EU and Japan reach net-zero for all greenhouse gases by 2050, whereas some other economies are assumed to take slightly longer to transition.

The Late Action scenario involves a sudden increase in the intensity of climate policy in 2031, following an initial period which despite global focus on climate issues, is characterised by insufficient or ineffective emissions reducing policies. There are many hypothetical triggers for such a shift. For example, a cumulative increase in significant climate-related events could materially strengthen the impetus for government action worldwide. Because the transition is delayed for 10 years, it must be more sudden to ensure that UK carbon dioxide emissions drop to net-zero before 2050.

4.1.2: Phase-out of fossil fuels

Transition policies lead to the phase-out of fossil fuels. This is associated with changes in overall energy use as well as by changes in the energy mix reducing the carbon intensity of energy.

In the Early and Late Action scenarios, fossil fuels are almost entirely replaced by renewables in the UK primary energy mix by 2050 (Chart 4.1).footnote [15] By then, renewables account for around 90% of UK energy needs and around 70% of global energy needs. The main reason for a lower proportion globally is higher demand for fossil fuels in developing regions. In these regions the development of infrastructure remains fossil-fuel intensive because there is not enough time within the scenario horizon to complete the transition to low-carbon production processes for items such as cement and steel.

The phase-out of fossil fuels occurs alongside significant improvements in energy efficiency, as well as changing regulation and user preferences. For example, in the Early Action and Late Action scenarios the UK Government introduces policies to improve energy efficiency of buildings and to advance a transition towards electric vehicles (see Box B for more details). The implications vary by sector (see Section 4.3.4: Sectoral differences).

Significant investment is needed to lower the cost and increase the deployment of low-carbon technologies. Transitioning to a net-zero economy requires investment flows to be channelled towards green electricity and storage, transport and industrial processes. It also requires investment in some carbon capture and storage for hard-to-abate emissions such as from aviation and animal agriculture. This shift takes place more rapidly in the Late Action scenario due to the delayed policy response and reduced availability of carbon sequestration technologies.

Without further policy intervention, in the No Additional Action scenario, fossil fuels continue to be the dominant source of primary energy, accounting for around 60% of the UK and 75% of the global primary energy mix in 2050.

Chart 4.1: In the Early and Late Action scenarios fossil fuels are almost entirely replaced by renewable energy in the UK

UK primary energy mix

Bars compare current UK energy mix with 2050 early and late action scenario projections. Renewables share increases by around 75 percentage points.

Footnotes

  • Sources: Network for Greening the Financial System and Bank calculations.

4.1.3: Commodity markets

One key uncertainty associated with transition is the future pathway for volumes and producer prices of fossil fuels.

In the No Additional Action scenario, global wholesale commodity prices (producer prices) rise in line with global demand and increasing extraction costs (Chart 4.2). In the Early Action and Late Action scenarios, producer fossil fuel prices are under downwards pressure from declining fossil fuel use, although producer ‘sell-off’ behaviour is not explicitly modelled. Lower producer prices of fossil fuels have a negative impact on businesses that extract fossil fuels, including those that are state-owned enterprises (see Section 4.3 for an overview of the impact on sovereign bond spreads). Rising carbon prices in the Early Action and Late Action scenarios create a wedge between consumer and producer prices.

Chart 4.2: In the Early Action and Late Action scenarios producer prices of fossil fuels fall, but rising carbon prices create a wedge between producer and user prices

Producer and user fossil fuel prices

Footnotes

  • Sources: National Institute of Economic and Social Research, Network for Greening the Financial System and Bank calculations.

4.2: Physical risks

Global mean temperatures have already increased by around 1.1°C from pre-industrial levels. In the Early and Late Action scenarios where deep reductions in emissions occur, changes in physical risks still materialise as the atmospheric concentration of greenhouse gases continues to increase. However, their impact is much smaller than in the No Additional Action.

In the No Additional Action scenario, governments around the world fail to meet their climate ambitions, with global temperatures increasing by 3.3°C relative to pre-industrial levels by the end of the scenario. This leads to severe and irreversible physical impacts. Chronic risks increase due to: rising temperatures, precipitation and sea level and due to changes in ecosystems. Acute risks also increase as the frequency and severity of weather events such as heatwaves, wildfires, tropical cyclones and flooding rise. Chronic and acute physical risks impact living and working conditions, affecting health, labour productivity and agriculture.footnote [16] Changes in physical hazards are unevenly distributed, with tropical and subtropical regions facing larger increases than higher latitudes.footnote [17]

The following sections discuss selected physical risk variables in the CBES scenarios and describe flood defence assumptions (Section 4.2.5).

4.2.1: Key physical risks in the UK

In the UK, climate change is expected to increase average temperature, increase precipitation in the winter months, reduce precipitation in the summer months, and cause sea level to rise.footnote [18]

The combination of climate change effects incorporated in the No Additional Action scenario leads to an increased risk of flooding in the UK. In addition, the UK also becomes more exposed to hazards such as subsidence and heatwaves.footnote [19]

By the end of the No Additional Action scenario, average winter precipitation in the UK increases by 25% compared to the late 20th century (Chart 4.3). Contributing to those average increases, extreme rainfall events also become more frequent. For example, Met Office research found that events similar to the record rainfall that occurred in the UK on 3 October 2020 (the UK’s wettest day on record) could become ten times more frequent for climatic conditions similar to those in year 10 of the No Additional Action scenario.

Chart 4.3: In the No Additional Action scenario, average winter precipitation in the UK rises by nearly 25% compared to the late 20th century

Change in the average summer and winter precipitation since the late 20th century in the CBES scenarios