As world leaders gather in Glasgow for the COP26 climate conference, an important – if obscure to most – announcement on financial regulation by the Bank of England’s Prudential Regulation Authority (PRA) went rather under the radar. Last week, the PRA announced it will consider whether it should change its regulatory capital framework, which could include requiring banks to hold extra capital to cover risks from climate change.
In essence, the focus of these regulatory requirements is to ensure financial institutions hold sufficient funding corresponding to the riskiness of their loans and other financial undertakings. Should those risks materialise, they could cover the losses and continue operating, without the need for government bailouts as in 2008.
As the impacts of extreme weather events continue to increase with the worsening of the climate emergency (physical risks), and fossil fuel investments are destined to decline in value to zero if the world leaders follow through with their net zero commitments (transition risks), central banks and regulators now widely recognise those risks as material to their price and financial stability mandates.
However, to date financial regulators have predominantly focused on protecting finance from climate change risks, rather than recognising and acting on destructive financial flows that continue to fuel the worsening climate emergency. This is reflected in the PRA’s latest report, with the discussion of new capital rules mainly concerned with quantifying risks to individual financial institutions. In fact, the PRA explicitly stresses that capital requirements are ‘not the right tool to address the underlying causes of climate change’, instead stating that they ‘should help provide resilience against its consequences (financial risks)’.
While the commitment to further work on climate-related risk management is welcome, the narrow approach fails to recognise that the best way to address climate risks is tackling drivers of climate change in the first place. The PRA is right to be considering how to strengthen capital requirements to account for climate risks, and the policy announcements on greening UK finance in the lead up to COP, in particular introduction of mandatory transition plans under the enhanced Sustainability Disclosure Requirements, are steps in the right direction. But these measures, focusing on climate risks to finance and to a large extent relying on free markets to self-adjust if only given more information (disclosures), risk repeating the mistakes of the pre-2008 lax regulatory approach and wasting years we do not have to realign finance with 1.5 ºC.
The PRA stresses its primary role in the transition is ensuring firms are managing their climate risks effectively. But to protect the soundness of the UK financial system, as well as to support the government’s goals now outlined in detail in the Net Zero Strategy, the Bank needs to go beyond mitigating hard-to-quantify micro-level climate risks to firms, and adapt a precautionary approach that accounts for those uncertainties and recognises the need to actively steer market actors towards a managed transition that protects macro-level stability. The Bank should build on the framework it proposed for greening its Corporate Bond Purchase Scheme, and develop capital requirements that not only reflect climate risks, but also reflect climate performance and target the emissions paths for regulated firms that are aligned with the government’s climate goals.
As the COP26 began last weekend, a coalition of NGOs including NEF called on the world leaders to recognise the role of capital rules in preventing the build-up of climate-related financial risks. To account for the risks that fossil fuel investments pose to planetary stability – with the International Energy Agency stressing that any new fossil fuel projects are incompatible with a transition to net zero — regulators should embrace the ‘One for One’ rule. This is a form of financial regulation that means for each pound/euro/dollar that finances fossil fuels, banks and insurers would have a pound/euro/dollar of their own funds held liable for potential losses. This basic risk management principle is already applied to other high-risk (yet difficult to measure exactly) exposures. For example, the Basel Committee recently recommended a one-for-one approach to some cryptocurrency exposures. This would provide a foundation to both protect financial stability and to protect climate by curbing finance going into harmful investments.
To help deliver the government’s ambitious Net Zero Strategy, the Bank of England must use all tools at its disposal to regulate private finance and guide private capital towards £50 – 60bn additional green investment a year. While UK-based banks continue to pour billions into fossil fuels, other countries are making important moves: China’s state-run Bank of China announced it will no longer provide financing for new coal projects overseas after 2021, while the US government embraced the precautionary approach to climate-related risks in last month’s executive order. The Bank has made a lot of progress on climate research and advocacy in recent years, but the time to keep 1.5 ºC alive is running out – our regulators must act with urgency matching this reality.