Assessing the Bank of England’s climate risk collateral reforms for their greening potential

By updating its collateral framework to reflect climate risks, the Bank of England not only protects its balance sheet but also encourages greener mortgage lending by commercial banks - but there is room to go further and complementary Government policy is needed to ensure equitable outcomes, write Irene Claeys, Ram Suresh Kumar and David Barmes.

The Bank of England has recently made significant progress in incorporating climate-related financial risks into its collateral framework. Several amendments were introduced earlier this year, all targeted at the Bank's residential mortgage assets, which make up most of its collateral holdings. These updates aim to shield the Bank's balance sheet from the physical risks of climate change and the economic impacts of transitioning to a low-carbon economy. But the benefits reach beyond risk management: they may also contribute to important greening effects across the broader economy through their impact on bank lending and asset prices.

What is the Bank's collateral framework and how has it been updated?

The collateral framework determines the eligibility criteria and valuation terms for assets that commercial banks use when they borrow from the Bank of England. The assets accepted as collateral -such as gilts, mortgage assets and corporate bonds - are subject to specific 'haircuts' to account for their risk profiles. This means that the Bank will only lend a fraction of an asset's value to reflect potential market value changes. The collateral framework is therefore critical in protecting the Bank's balance sheet against potential losses.

The collateral framework can also influence commercial banks' lending and investment decisions. Commercial banks typically place a premium on assets that the Bank's collateral framework deems to be high-quality, as these can be used to borrow on better terms. By updating the rules on collateral eligibility and haircuts to reflect climate-related risks, these amendments therefore have the potential to steer bank lending behaviour and asset holdings in a way that generates greening effects across the wider economy.

The Bank has introduced three changes to its collateral framework:

• Energy Performance Certificate (EPC) eligibility criteria for buy-to-let mortgages: The Bank has adjusted its eligibility criteria for buy-to-let mortgages, requiring them to meet the Government's Domestic Minimum Energy Efficiency Standard (MEES) Regulations. This means that to serve as eligible collateral, buy-to-let mortgages must have an EPC rating of at least 'E' (on a scale from 'A' to 'G') or hold a valid exemption.
• Haircuts based on energy price shocks for owner-occupied mortgages: Properties with low EPC ratings are at heightened risk from energy price fluctuations, which could increase the likelihood of default for owner-occupied households unable to meet rising energy costs or the cost of retrofitting to increase energy efficiency. The Bank uses the Late Action scenario in its Climate Biennial Exploratory Scenario (CBES) - which assumes a delayed and disorderly transition to net zero - to project energy price shocks and model the financial strain on households in different EPC bands. It incorporates these effects into its haircut models to assign larger haircuts to owner-occupied mortgages with lower (or missing) EPC ratings.
• Haircuts reflecting flood risk for all residential mortgages: Climate change is escalating flood risk in certain areas and could increase mortgage default in flood-prone regions due to rising flood insurance costs or loss of insurance coverage in the most vulnerable areas. Although insurance premia are currently capped by the Government-sponsored flood reinsurance scheme Flood Re, this expires in 2039, and the Bank conservatively assumes that it will not be renewed. The Bank applies larger haircuts to residential mortgages in areas exposed to flood risk, using modelling based on the Intergovernmental Panel on Climate Change's Representative Concentration Pathway (RCP) 8.5 scenario (a worst-case no climate action scenario). While these represent conservative assumptions, they serve to increase the protection of the Bank's balance sheet.

Implications for the green transition

Beyond the benefits of risk management, the above measures also have implications for the green transition, by influencing banks' lending behaviour to encourage improvements in energy efficiency and initiatives to increase resilience to physical risks:

• Reinforcing energy efficiency: By aligning the collateral eligibility of buy-to-let mortgages with the Government's MEES regulations, the Bank reinforces regulatory standards on energy efficiency for rental properties. The Bank's measure signals the existence of gaps in compliance with MEES, suggesting that some commercial banks may still be underwriting buy-to-let mortgages on 'F'- and 'G'-rated properties (without MEES exemptions or contractual retrofitting agreements). Consequently, this adjustment not only protects the Bank but also discourages non-compliance, making MEES regulations more binding. Penalties will be imposed on the valuations of 'F'- and 'G'-rated properties and returns to retrofitting these properties will be increased, incentivising greater energy efficiency. It is expected that the Government will increase MEES EPC thresholds in the future, at which point the Bank will benefit from updating its eligibility criteria to continue to track government policy.
• Reducing demand for energy-inefficient properties: The energy price shock haircuts for owner-occupied mortgages allow the Bank to price in the risk of energy price shocks - which disproportionately impact properties with lower EPC ratings - to owner-occupied mortgages in collateral holdings. This amendment is likely to worsen the terms of lending (i.e. increase interest rates) that commercial banks offer to owner-occupied mortgages with lower EPC ratings, reducing the demand for, and prices of, energy-inefficient properties, and steering the market to price energy shocks into property values. Pricing-in such risks is not only desirable from an economic efficiency perspective, but also supports the green transition by encouraging the construction of more energy-efficient homes and retrofitting of the existing housing stock.
• Encouraging flood risk mitigation: The Bank incorporates future flood risk based on the IPCC's RCP 8.5 scenario, which reflects an extreme worst case from climate inaction as opposed to the most probable worst case. The Bank also assumes that Flood Re, which caps flood insurance costs and ensures high coverage, will not be renewed after 2039. By incorporating the risks of higher flood insurance premia and the loss of insurance for properties in flood-prone areas, higher flood risk haircuts are likely to increase mortgage rates and depress demand for these properties. This will encourage homeowners as well as local and central government to undertake risk mitigation and resilience measures (such as constructing flood defences). It will also disincentivise new housing supply in flood-prone areas, guarding against exacerbated physical climate risk.

Government policy is needed to ensure equity

While the Bank's reforms contribute to climate risk management and promote a greener economy, they may also adversely impact certain groups, such as lower-income homeowners with energy-inefficient properties or those in flood-prone areas. Government policies could provide additional support to affected households and help complement the Bank's risk-management goals with a fair transition to a low-carbon and resilient housing sector, for example through:

• Providing better means-tested grants and low-interest loans for retrofitting to help lower-income homeowners undertake energy efficiency upgrades and flood-proofing measures.
• Building resilience and ensuring sustainable flood insurance, assessing the longer-term viability and evolution of Flood Re and providing a coherent transition strategy to ensure both household-level flood risk reduction and broader structural changes in urban planning and floodplain management to mitigate future risks.

Policy coordination for a fair, green transition

The Bank's measures on residential mortgages are an important first step in recognising climate risks in its collateral framework and are a positive move for fostering a green economy. The Bank could go further and apply similar risk adjustments to a broader range of assets. For example, higher haircuts could be applied to corporate bonds from high-carbon sectors, such as fossil fuel production, to account for transition risks. Additionally, the Bank could expand its consideration of physical risks to include heatwaves, drought and coastal erosion. Complementary government policies, such as incentives for energy efficiency upgrades and enhanced flood resilience, can encourage a fair transition and protect vulnerable households.

The Bank of England and the Government should work together towards creating a robust climate risk framework that supports financial risk management, while driving an equitable green transition.