Does prudential policy have a role to play in tackling climate change?

The start of 2022 marked the official incorporation of climate change into the core supervisory process of the UK Prudential Regulation Authority (PRA), the regulator of banks and other large financial institutions. The PRA is now actively supervising UK banks in line with the expectations in Supervisory Statement 3/19 (SS).   This means their management of climate-related financial risks has become a legitimate target for the deployment of the regulatory toolkit.

It has been suggested that a more climate-sensitive prudential framework would take account of the impact of climate change on "traditional" credit, market, liquidity and operational risk categories, as well as facilitate the transition to a more sustainable economy.

Existing framework 

The purpose of prudential regulation is, in short, to ensure that firms have enough capital (and liquidity) to operate effectively through periods of economic stress without causing harm to their customers, markets and the wider financial system.

As it stands, climate-related financial risks are already captured in the current framework. UK banks are required to ensure they have sufficient capital to be resilient against all material risks, including those stemming from climate change.  Furthermore, the PRA can resort to its wider supervisory toolkit to impose capital add-ons where it considers there to be significant weaknesses in banks’ (climate-related) financial risk management and governance.

Climate is also firmly integrated into Bank of England scenario analysis and stress testing. The result of the Climate Biennial Exploratory Scenario (CBES), used to assess the impact of climate-related risks on the UK financial system, is due to be published in May. 

Furthermore, banks are required to disclose information on material risks within their Pillar 3 disclosures, as required under the Capital Requirements Regulation, and on principal risks and uncertainties in their Strategic Report, as required under the UK Companies Act, supplementing these disclosures where appropriate. 

Looking ahead

The question now rattling the cage of financial institutions, regulators and policymakers is this: does the regulatory capital framework need to be further enhanced to address climate-related risks? 

The PRA’s Climate Change Adaption Report (a must-read for anyone interested in the topic), published in October 2021, made several key findings .

First, that capital can be used for the consequences, but not the causes of climate change. (Prudential action that is aimed at addressing the causes of climate change could, some think, have unintended consequences on financial stability.) This effectively puts to bed the suggestion that regulators should introduce ‘carbon penalising factors’ and/or ‘green supporting factors’ for exposures to assets or counterparties that are respectively more or less carbon-intensive. Others have observed that the foundation that clean investments are, in fact, less financially risky has yet to be established and that “offering benefits solely for desirable policy goals would undermine the central purpose of capital rules and would decrease the resilience of the financial system” (according to Graham Steele, who is now Assistant Secretary of the Treasury for Financial Institutions in the US).

Second, although climate-related financial risks are partially captured by current frameworks, there are important gaps: “capability” gaps, which make it difficult or impossible for firms to quantify and capture risks fully within the current framework; “microprudential regime” gaps related to firm-specific exposures, one issue being the use of short-term calibrations based on historical data; and “macroprudential regime” gaps related to the way in which system-wide exposures to climate-related financial risks are addressed, most notably risks that increase over time. Some of the challenges identified in the PRA's report are similarly addressed in a study conducted on behalf of the European Commission on the integration of ESG factors into the EU banking prudential framework.

The need to take action, through capital or non-capital interventions, ultimately depends on the PRA’s assessment of the materiality of these gaps. But this is hard to estimate because it depends on the regulator’s view on a number of important points: time horizons for capital setting, which scenarios to use, the level of firm exposures and the identification and expected impact of other non-capital tools.

And so the PRA Report concluded: “determining whether changes to the design, use or calibration of the existing capital framework are needed to address climate-related financial risks beyond what is currently in place is complicated and needs to be supported by further work and research”. Over the coming year, the PRA together with the Bank of England, will issue a ‘Call for Papers’ and host a Research Conference on the interaction between climate change and capital (probably in the fourth quarter of 2022). There’ll then be a follow-up report on the use of capital including on the role of any future scenario exercises.

The PRA may well be reluctant to adjust the capital regime unless such changes are also adopted as international standards by the Basel Committee, the primary global standard setter for the prudential regulation of banks. In April 2021, Basel released two analytical reports which, in a similar vein to the PRA, recommended further research: “climate risk drivers can be captured in traditional financial risk categories. But additional work is needed to connect climate risk drivers to banks’ exposures and to reliably estimate such risks. . . . Building on this analytical work, the Committee will investigate the extent to which climate-related financial risks can be addressed within the existing Basel Framework of capital requirements.”

This is new territory for everyone. But there is growing pressure to transform analysis to conclusion.