Climate Financial Regulation: What is on the Horizon?

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.

Jo Paisley

But these supervisors also operate within a global supervisory network, including formal regulatory standard setters, such as the Basel Committee on Banking Supervision, and more informal alliances, such as the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Consequently, they need to strike a balance between establishing their own regimes and working with others, cognizant that climate change is a truly global problem that requires global responses.

Which Risks are in Scope?

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.

The early emphasis from these supervisors was on integration in firms’ risk management frameworks. In April 2019, the PRA was the first supervisor to set formal supervisory expectations for banks and insurers for their management of climate-related financial risks. The ECB followed with a broader focus, publishing a guide on climate-related and environmental risks in November 2020.

How Likely are we to See Supervisory Consensus on the Scope of Risks?

The NGFS was launched in 2017 and is a ‘coalition of the willing’ – a group of central banks and supervisors that voluntarily share best practices on climate and environmental risk management. Recent research, however, has broadened their focus, setting out a comprehensive agenda for how central banks and supervisors should address the financial and economic risks stemming from biodiversity loss.  

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.

Increasingly, there is now a view that climate change and environmental issues need to be tackled jointly, because they are so highly interconnected. In 2021, there was a joint IPCC/IPBES workshop that produced their first-ever collaboration.

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.

The PRA launched its exploratory scenario analysis exercise in 2021. It was designed to foster improvements in the management of climate risks and to test the resiliency of the largest banks and insurers - and the financial system - to different climate scenarios.

The ECB ran a top-down, economy-wide stress test in 2021. This exercise helped inform the design of the supervisory, bottom-up stress test the ECB launched in January 2022. It will be interesting to see the estimated size of the impacts when the results of these exercises are published.

Climate Capital Requirements?

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.

A recent speech by Frank Elderson, ECB Executive Board member and Vice-Chair of the Supervisory Board of the ECB, suggests that climate and environmental risks are likely to influence the way that the ECB sets capital requirements. In 2022, the ECB is undertaking a comprehensive review of banks’ practices related to strategy, governance and management of climate and environmental risks. Elderson noted that the ECB expects insights from both the climate stress test and their review to feed qualitatively into firms’ Supervisory and Review and Evaluation Process (SREP) scores, which may have an indirect impact on capital requirements.

Stepping back to a more global perspective, the issue of climate capital requirements is being debated actively. A recent Financial Stability Institute (FSI) brief from the Bank for International Settlements (BIS) examines capital options and the case for adjustments to the three pillars of the Basel framework for banks’ capital:

• 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.

Parting Thoughts

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.

GARP’s Sustainability and Climate Risk (SCR) Certificate provides the foundation needed to tackle climate related risks and help prepare for future regulatory climate mandates.