U.K. banks are likely underestimating their potential losses in the event of a severe climate change scenario, according to the Bank of England.

The BoE's Climate Biennial Exploratory Scenario assessed seven banks under three stress scenarios: early, late or no additional action against climate change. The seven — HSBC Holdings PLC, Barclays PLC, Lloyds Banking Group PLC, NatWest Group PLC, Standard Chartered PLC, Nationwide Building Society and the U.K. branch of Banco Santander SA — represent about 70% of U.K. bank lending. They projected additional cumulative loan losses of about £60 billion towards 2050 under the most severe climate change scenario, which assumes no additional policy measures are adopted to reduce global warming.

This figure may be "misleading," said Sam Woods, deputy governor for prudential regulation, because of the different end-points of the scenarios explored in the stress tests. He suggested that the actual loan loss figure would likely be higher than the banks' projection as there are greater risks of uncaptured or unanticipated losses in this most severe case.

In comparison, the lenders project between £85 billion and £110 billion in additional cumulative loan losses towards 2050 under the less-severe early and late action scenarios. These two scenarios assess transition risks, which are particularly linked to rising carbon prices.

The 'no additional action' scenario assessed the impact of primarily higher physical risks, such as flooding and more extreme weather conditions. It assumed that global warming relative to pre-industrial times reaches 3.3 degrees C by 2050.

Despite the lower loan losses under this severe scenario, it delivers the worst outcome of the three scenarios, even if a "naïve comparison of loss rates" might suggest otherwise, said Woods. In contrast to the two transition paths, this scenario "only captures a subset of the costs of climate change," and the impact will "persist indefinitely" beyond the 30-year horizon of the exercise, according to the BoE.

The regulator also suggested there could be significant uncertainties associated with this scenario, saying there is "evidence that banks were less well equipped to assess thoroughly the impact of physical risks." Beyond losses, U.K. lenders also envisaged far fewer new business opportunities in the most severe scenario relative to the two transition scenarios, due to worsened macroeconomic prospects.

While banks face growing loan losses regardless of scenario, they could still act to mitigate the risks. The stress test is based on "the simplifying assumption" that banks' balance sheets stay fixed in the next 30 years when, "in reality … business models are likely to respond to climate risks over time," the BoE said. The exercise itself has already boosted banks' efforts, and institutions "are making good progress in some aspects of their climate risk management," it said.

Still, there is much to be done for U.K. banks to understand and manage their exposure to climate risk, the regulator said.

While the stress test does not provide bank-by-bank data, some U.K. banks have commented on the findings in their annual sustainability reports. Barclays said its business was resilient under the stress test scenarios, and that its net-zero plans "in part mitigates some of the risk" in at least the two transition scenarios. Standard Chartered said that the longer term risk related to climate "will be addressed through its business strategy and financial planning as the group implements its net-zero journey."

The stress-test findings are unlikely to prompt radical business model changes in the short term, but the exercise will "force management at the more monoline banks to begin to consider business model climate vulnerabilities more closely," according to Fitch Ratings.

HSBC, Barclays, Lloyds Bank, NatWest, Standard Chartered and Santander did not respond to requests for comment by the time of publication.