Mastering climate-related risk for banks

The PRA has released its highly anticipated consultation paper (CP10/25) and a draft supervisory statement, setting out enhanced expectations for banks' management of climate-related risk (see summary here). The principles-based proposals include key elements deemed essential by the PRA for an effective climate risk framework, focusing on validation and governance. 

The PRA acknowledges the increasing importance and complexity of climate-related risks, intensified by both acute events such as extreme weather and chronic impacts, for example rising sea levels.

Recent regulatory assessments have revealed gaps in firms’ governance and validation frameworks, particularly in how they manage financial and operational risks linked to climate change. The PRA has therefore proposed:

• Governance enhancements: the PRA’s updated proposals aim to establish clearer governance expectations, drawing on international standards and supervisory insights. Boards and senior management will be expected to demonstrate active oversight of climate-related risks, ensuring these are integrated into strategic decision-making and risk appetite frameworks.
• Validation flexibility with accountability: recognising the challenges in modelling and scenario analysis, the PRA supports innovative, firm-specific approaches. However, these must be underpinned by robust validation processes, including independent review, documentation of assumptions, and regular performance monitoring to ensure reliability and consistency.
• Raising risk management standards: the proposals seek to elevate the governance and validation standards across UK firms by embedding climate risk into existing risk management structures. This includes assigning clear responsibilities, enhancing internal audit functions, and ensuring that climate risk data and models are subject to rigorous validation and challenge.

The enhanced expectations are intended to strengthen the safety and soundness of firms, thereby enhancing overall financial stability.

The expectations are applicable to banks and insurers, reflecting the broad exposure of these institutions to both physical and transition risks arising from climate change. These risks can lead to direct financial losses and necessitate strategic shifts in business models. The PRA underscores the systemic nature of climate-related risks, the uncertainty they present, and the strategic management challenges firms must address.

• Strategic integration and oversight: many firms have yet to integrate climate risk and scenario analysis fully into their strategic decision-making processes. This gap highlights the need for stronger governance structures, where boards and senior executives are accountable for embedding climate considerations into long-term planning.
• Reverse stress testing and risk frameworks: the PRA emphasises the importance of incorporating reverse stress testing into firms’ risk management frameworks. This requires robust validation mechanisms to ensure that extreme but plausible climate scenarios are adequately captured and inform risk appetite and contingency planning.
• Governance and model validation: while firms have made progress in developing climate risk capabilities, governance and validation practices remain uneven. The PRA’s proposals set clearer expectations to guide firms in:
  • Enhancing risk governance frameworks to include climate-related responsibilities.
  • Establishing validation protocols for climate models, data and assumptions.
  • Ensuring internal audit and challenge functions are equipped to assess climate risk processes.

By reinforcing governance and validation standards, the PRA seeks to strengthen firms’ resilience, promote sound risk management and support effective competition in the financial sector.

To effectively manage climate-related risks, firms must establish a robust governance structure that embeds climate considerations into strategic decision-making. This includes setting a clear climate risk appetite, aligning business strategy with climate goals, and ensuring that risk management practices are validated and continuously improved.

Key areas of focus for firms should include:

1. Leadership responsibilities: The board plays a central role in fostering a culture of climate risk awareness and accountability. Key governance expectations include:

• Information provision: management must ensure the board receives comprehensive climate risk assessments, enabling informed oversight and strategic direction.
• Training and capacity building: regular training programs should be implemented to keep the board updated on climate science, regulatory developments, and risk management best practices.
• Model understanding: boards must understand the strengths, limitations, and assumptions of climate models and scenario analyses, including sources of uncertainty and practical implications.

CP 10/25 introduces a stronger regulatory focus on the governance, validation and strategic integration of climate-related financial risks. In response, firms should look to enhance their climate risk frameworks through the following key actions:

• Establishing strategic oversight: ensuring the board of directors is actively engaged in setting the strategic direction for climate risk, aligning it with the firm’s overall objectives and regulatory requirements.
• Enable informed decision-making: integrating robust scenario analysis and reverse stress testing into board-level discussions to support well-informed, forward-looking decisions on climate risk.
• Implement ongoing validation: developing and maintaining governance structures that support continuous validation of climate risk models, assumptions, and metrics to ensure their accuracy and relevance over time.
• Enhance accountability and transparency: putting in place clear documentation and internal reporting processes to track how climate risk appetite and strategic direction are defined, monitored, and revised.

KPMG has a dedicated Risk and Regulatory Advisory practice which includes specialists in climate risk and climate-related modelling. We can support financial institutions in addressing the business and regulatory challenges of climate-related risk, applying our experience, our understanding of industry bodies and evolving regulatory expectations, and our specialisms across different markets and risk types. 

Our services include:

Modelling and analytics: including benchmarking and gap analysis of existing capabilities, incorporating climate risk into stress testing and credit decisioning models, and climate-adjusted asset valuation modelling. 

Scenario analysis: including climate risk driver identification and materiality assessment, tailored climate scenarios, reverse stress testing and climate risk quantification training. 

Model validation: including validation of climate risk and ESG models, model enhancement identification and planning, and internal audit support.

To discuss further, please reach out to Andrew Fulton, James Philpott, Thomas Clarke or Himanshu Bagga.