Climate Financial Regulation: What is on the Horizon?
Supervisors in the EU, the UK and across the world have intensified their regulation of the financial risks resulting from climate change, forcing financial institutions to ponder what’s next. Both regulators and firms must take into account everything from the scope of risks to the use of scenario analysis to potential climate capital requirements.
Tuesday, March 29, 2022
By Jo Paisley
Ambitious climate goals have been adopted in both the EU and the UK. As these economies migrate to net-zero emissions, supervisors know that financial firms in these regions will be facing domestic transition risks. What’s more, as global warming continues, they will also be contending with increasing physical risks.
One key question facing supervisors is the scope of risks that they want financial firms to consider. The UK’s Prudential Regulation Authority (PRA) has focused so far on the risks arising from climate change. The European Central Bank (ECB) chose a wider focus, covering environmental issues such as air, water and land pollution, water stress and biodiversity loss, as well as climate issues.
If we look beyond the supervisory world, until recently even scientific research and policymaking had tended to look at climate change and biodiversity as distinct topics. Each issue has its own international convention (the UN Framework Convention on Climate Change, and the Convention on Biological Diversity, respectively), and each has an intergovernmental body (including the Intergovernmental Panel on Climate Change (IPCC), and the Intergovernmental Platform on Biodiversity and Ecosystem Services (IPBES)) that assesses available knowledge.
This important development has no doubt underpinned the increased focus on the interactions across climate, ecosystems (including their biodiversity) and human society in the latest IPCC Report on Impacts, Adaptation and Vulnerability. This report outlines the benefits from building the resilience of biodiversity - not just with respect to livelihoods, human health and food provisions (etc.), but also for disaster risk reduction and climate change adaptation and mitigation.
Another way to think about this is to recognize that measures to protect biodiversity are almost always beneficial to the climate. However, some measures to mitigate or adapt to climate change could have harmful effects on biodiversity.
Overall, it seems sensible for firms to recognize that even if their supervisor is currently focused on climate risks, the scope is likely to expand. From a risk management perspective, it makes sense to incorporate broader environmental risks within your scope of focus, because they are so interconnected.
The Use of Scenario Analysis
Another area where supervisors have made progress on embedding within their prudential framework is in the use of scenario analysis or stress testing exercises. Scenario analysis is an obvious tool for supervisors to use to assess climate-related financial risks, as it is forward-looking and can be particularly helpful when the future is uncertain. That said, there are distinct challenges, particularly the time horizons, availability of data and modelling techniques. Notwithstanding these potential roadblocks, supervisors in the UK and the EU have both been early adopters.
But an open issue is whether supervisors intend to set capital requirements against climate and environmental risks.
The PRA’s 2021 Climate Change Adaptation report argues that capital can be used to address the consequences, not the causes of climate change. In other words, capital should not be used as a substitute for government climate policy. But they argue that more research and analysis is needed.
Pillar 1 covers minimum capital requirements for credit, market and operational risk. But these requirements are calibrated for a one-year time horizon based on historical loss experience. This poses obvious challenges when it comes to climate risks, with limited historic data and a more forward-looking approach over a longer time horizon seeming more appropriate given the nature of the risks. There is also global discussion about whether risk weightings should be changed. Work by the NGFS, for example, could not establish any strong conclusion on whether ‘brown’ assets were more risky than "green" ones.
Pillar 2 covers the supervisory review process and offers more flexibility than Pillar 1. Under Pillar 2, supervisors have the scope to assess the adequacy of a firm’s governance of risk management in identifying/managing/mitigating the risks. Moreover, the results of any scenario analysis exercises might also inform the scale of potential impacts of climate change. The issue with Pillar 2, however, is how to ensure international consistency. Francois Villeroy de Galhau, Governor of the Banque de France, indicated in a recent speech that he was in favor of a Pillar 2 approach – with any capital add-ons remaining "wholly risk-based, rather than conceptually color-based."
Pillar 3 rests on using market discipline through disclosures to drive transparency and allow market incentives to work properly. There is a great deal of work underway on disclosures, but a big debate here is whether they are effective at helping solve climate change.
There’s also the potential for macroprudential capital measures, which can address systemic risks. The BIS is not convinced these will be successful, partly due to concerns over potential perverse side effects.
This is a crucial area to watch. In Q4 2022, the PRA will host a capital and climate conference where they intend to discuss in more depth how the capital framework might be adjusted to take account of climate-related financial risk. It will be interesting to see if a consensus view emerges from that.
While significant progress has been made on climate-risk regulation, there is still much more work to be done. We have to better understand and manage, for example, the multitude of environmental risks. For supervisors in some regions, this might require the broadening the scope of risks and/or changing the capital framework.
Whatever your views on these issues, one thing is for sure: they are not going away any time soon. Moreover, there is an urgent need for risk professionals to understand this increasingly complex and fast-moving landscape.
Jo Paisley, President of the GARP Risk Institute (GRI), has worked on a variety of risk areas at GRI, including stress testing, operational resilience, model risk management and climate risk. Her career prior to joining GARP spanned public and private sectors, including working as the Director of the Supervisory Risk Specialist Division within the Prudential Regulation Authority and as Global Head of Stress Testing at HSBC.