Capital requirements instituted in the wake of the financial crisis are not fit to deal with the risks climate change poses. Following the 2008 crash, which necessitated massive bailouts of under-capitalised financial firms, regulators have significantly revamped and tightened requirements for banks under the internationally agreed Basel III framework.
As ever, policy-makers set out to ‘fight the last war’ by developing risk metrics and mitigation measures calibrated on backward-looking data and the 2008 experience. So while the reforms have improved the resilience of banks against traditional sources of financial risk, they were not designed to tackle the emerging climate-related risks.
The climate crisis poses a threat to the financial system and macroeconomic stability in two primary ways. First, the physical risks of increasingly frequent and severe weather events and environmental damage that will lead to financial losses. Second, the transition risks of the UK and other economies moving towards net-zero emissions, resulting in fossil fuel assets continually declining in value (to zero) and eventually becoming ‘stranded’.
In the UK, as the institutions tasked with protecting financial stability, the Bank of England (BoE) and the Prudential Regulation Authority (PRA) must act accordingly.
However, the climate-related risks are forward-looking (past data being a poor predictor of future impacts of the worsening climate crisis) and characterised by ‘radical uncertainty’. Therefore, traditional approaches that rely on calibrating safe levels of capital using historical data are not fit for purpose.
Radical uncertainty
The growing understanding of this conundrum has led regulators globally to begin re-evaluating their capital frameworks. Last October, the BoE and PRA hosted a high-profile ‘Climate and Capital’ conference, pushing forward the debate among international regulators and academics.
The Basel Committee on Banking Supervision (BCBS), meanwhile, published a set of principles for managing and supervising climate-related financial risks and clarified how these can be applied in the existing Basel Framework.
The latest BCBS guidance called on banks to adopt a ‘conservative approach’ when faced with limited data and the uncertainty of climate-related risks. But this relies on individual financial supervisors setting high standards and enforcing compliance of the financial firms they supervise. The BoE and PRA previously committed to publish their updated stance by the end of 2022, but this has been delayed, with indications that UK regulators may delay any action until further international reforms are agreed.
One of the reasons regulators give for their hesitancy is the apparent complexity of incorporating ‘radical uncertainty’, feedback loops and long-time horizons of climate risks into a framework constructed to mitigate short-term financial disturbances. For example, risk weights to reflect differences in riskiness between different types of assets are calibrated to cover unexpected credit losses over a one-year period. Potentially irreversible and devastating damages further into the future, therefore, fall outside the framework.
Echoing the words of (now former) global head of responsible investment at HSBC Asset Management Stuart Kirk: “Who cares if Miami is six metres underwater in 100 years?”
None other than the BoE’s former governor Mark Carney highlighted this ‘tragedy of the horizon’ in a speech more than seven years ago. But BoE analysts argued last year that determining an appropriate time horizon and which risk weights to change still pose methodological challenges, suggesting more research is needed.
Overcoming complexity
Yet, the simple fact is that new fossil assets are at high risk of losing value due to the net-zero transition. To remain with a chance of limiting global warming to 1.5C, global oil and gas production must decline by 3% each year until 2050, and 60% of oil and fossil methane gas reserves must remain unextracted.
The one-for-one rule ensures financial firms are sufficiently capitalised against potential losses and also mitigates physical risks to the economy
If our regulators delay action due to its complexity, banks and insurers will be increasingly exposed to losses from stranded assets. And ongoing fossil fuel financing will continue to worsen the climate crisis and deepen the resulting threats to finance and the wider economy.
The one-for-one rule, where spending on financing for such activities must be matched with the same spending of a lender’s own funds against potential losses, offers a solution to this complex problem – similar to the approach already taken towards risky crypto assets.
It advocates a precautionary approach that avoids regulators spending years on futile attempts to quantify climate-related risks and instead encourages them to apply maximum risk weights to the most climate-risky assets, i.e. those with the worst climate impacts and therefore most exposed to transition risks under 1.5C-aligned decarbonisation.
The proposed rule not only ensures individual financial firms are sufficiently capitalised against potential losses on fossil assets, it also mitigates the physical risks to the economy from environmental damage fuelled by new fossil fuel projects. The framework could be further refined by introducing a climate systemic risk buffer, to internalise climate risks for financial institutions with the largest exposures that fuel those risks.
Taking action in the UK and beyond
The UK government must lead the way on tackling climate change through public investment, reforming taxes and subsidies, strengthening regulation, introducing a statutory objective for regulators to align the financial system with 1.5C, and delivering an improved strategy for greening finance.
And the BoE must play its part, working with the government to steer credit towards green investments and protect UK financial stability from growing climate-related risks, as the New Economics Foundation and 40 co-signatories urged in an open letter to governor Andrew Bailey and PRA CEO Sam Woods.
As the CEO of Triodos Bank, Bevis Watts, commented: “The Bank of England and the PRA must shift beyond merely analysing climate-related risks to decisively tackling them. The ongoing review of the capital requirements framework is a perfect opportunity to address the high risks associated with lending to new fossil fuel projects. These potentially stranded assets are both exposed to transition risks and contribute to the build-up of physical risks by fuelling the climate crisis. To safeguard long-term financial stability, the bank should adopt a precautionary approach and introduce higher capital requirements on activities that contribute to the build-up of climate risks.”
Ultimately, the climate crisis requires coordinated action at a global level. By moving to tackle climate-related risks with necessary urgency, the BoE could play a pivotal role in steering the Basel Committee towards a robust internationally agreed approach.
Lukasz Krebel is an economist for the New Economics Foundation, a UK think tank.
