Climate scenario analysis in financial services firms: strengthening board oversight and governance
The Bank of England’s (PRA’s) ‘Enhancing banks’ and insurers’ approaches to managing climate-related risk’ has provoked debate on how financial services firms can use climate scenario analysis and planning, not just for regulatory purposes, but also as a strategic tool. Strategy being very much the domain of the board, the PRA’s consultation helps focus board members’ attention on having oversight of climate scenario analysis, working out how to use it, and embedding the findings into strategy to future proof the business.
To explore this further, read our latest briefing:
Navigating tomorrow today: Scenario analysis for financial sector boards
As we have seen from COP30, the world is fractured on climate. We simply do not know what – in terms of sectors and individual businesses – will remain as we seek to reach net zero; and what will no longer be viable. It is uncertain how the economy will evolve, but it is foreseeable that we will encounter growing physical risk events and a transition away from fossil fuels. How this manifests, over what time horizons and how disruptive this may be, presents uncertainty and ambiguity.
Climate risk is systemic risk; it is all consuming. And there are not just physical risks to consider but also transition risks and a host of other risks. That is why a new tool is needed – there is just too much uncertainty to depend on traditional tools.
Scenario analysis itself is not new; it is very similar to stress-testing. The aim of scenario analysis is to test how a business will operate under different scenarios; but understanding those scenarios is at the heart of the challenge.
Whichever scenario you look at, the numbers will not be an exact or accurate indicator of precisely what will occur in the future. Rather, the purpose is to think broadly. The real benefit lies in getting a landscape of probable futures. This provides a key iterative tool for managing risk and materiality in an uncertain future.
Boards are on the hook. What the PRA is looking for in their latest consultation document is coherence between a firm’s strategy and its climate targets. It is for boards to challenge the climate scenarios presented to them to ensure that the thinking behind them is robust and then to connect the dots between that analysis, risk management and strategy. Boards should approach scenario analysis with curiosity and humility. Early engagement is also vital; and boards should remain engaged as the performance of scenario analysis is not a case of ‘one and done’. It is a long-term strategic imperative.
In my opinion, the topic chosen is the most important one; I found it extremely useful to listen to the speakers as well as to exchange ideas in the breakout group.
- Event Attendee, Scenario Analysis & Planning in Financial Firms: Strengthening Board Oversight and Governance
This is a difficult, complex endeavour and many firms aren’t there yet. Choosing the right scenario is tricky and climate data itself is complicated. There is no comparable backward-looking data on climate. We must think differently. This is why the PRA is putting so much emphasis on this issue.
Climate scenario analysis should be core to financial services firms’ strategy – it is the differentiator. What will happen in the future depends on actions taken now, and central to this is how financial firms invest. Feedback from the session was largely aligned and included the following key points:
- Progress is patchy: There is a wide range of progress on climate scenario analysis: some firms are just getting started while others are in active discussion. Board members are reporting lots of different stages of the journey.
- Scenarios can support investment decisions: There are both obligations and opportunities for financial services firms derived from climate scenario analysis. Some sectors will rise – especially those rooted in new rapidly evolving technology – while others will fall away. Understanding these different probable futures and how they relate to a firm’s business decision making is vital for boards across the finance sector.
- Upskilling is needed: There is a need for education and confidence-building at board level. Just one area of complexity is the huge range of new technologies available, including AI. The board should become equipped to have these conversations.
- Analysis should be shared: A challenge for some boards is how to disseminate and engage with information related to climate scenario analysis from the risk committee (or a subsidiary board) and across the whole (main) board so that the findings can become central to strategy.
- Scenario analysis is more than just compliance exercise: How the board should step back and think about the outcomes of climate scenario analysis is a further challenge. It is easy for it to become associated with compliance when it should really be considered a strategic tool. Boards can derive significant value from scenario analysis if engaged with effectively.
- Verification matters, but it isn’t the whole picture: Should the outcomes of climate scenario analysis be verified and validated? Can boards rely on this information? These are key questions, but discussions highlighted how the modelling is only one part of the picture; there is huge value in discussing plausible scenarios even when it is impossible to verify all elements of the data.
- Scenario storytelling is a strategic skill: Boards can benefit from using narratives within climate scenario analysis in addition to quantitative data. It tells a story and goes beyond the numbers.
- Indirect impacts can be profound: Climate scenario analysis presents indirect climate impacts for banks, but they are still very real. Climate scenarios can reveal cascading risks, and understanding these can help firms build resilience now.
- Climate risks are increasingly material now: Boards should ask questions about what is material in the short-term too and consider how the answers to those questions relate to the business.
- Tipping points can concentrate minds: Identifying tipping points and how these may affect a firm, is helpful for boards – this is a powerful way to engage NEDs.
Certainly useful, both for the personal study ideas that emerged and because I was able to see how other boards approach this topic.
- Event Attendee, Scenario Analysis & Planning in Financial Firms: Strengthening Board Oversight and Governance
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