Mandatory prudential transition plans could help banks manage the shift to net-zero and reduce their exposure to climate risk, says a paper published by the Grantham Research Institute on Climate Change and the Environment. Experts speaking in a webinar this week backed the paper’s conclusions and suggested the proposals could benefit the wider transition.
Why do banks need a climate transition plan?
Voluntary agreements and, increasingly, regulation mean banks must put together transition plans showing how they plan to meet certain environmental objectives – particularly in the EU. Today, such plans generally need to demonstrate how a financial institution will bring its business model, strategy and investments in line with the commitment of the Paris Agreement to keep global warming below 1.5 degrees above pre-industrial levels. Going forward, however, transition plans will also need to cover nature goals, such as those in the Biodiversity Global Framework agreed at COP15 in Montreal in December 2022.
Why would mandatory prudential transition plans help banks?
The Grantham Institute argues that a third type of plan – namely mandatory prudential transition plans that focus on the risks of misalignment with net-zero targets – would better enable those in the financial ecosystem to assess and monitor progress. In the EU, policy-makers are already discussing whether to introduce such plans as part of the ‘single rulebook’, which aims to provide a set of harmonised prudential rules for financial institutions.
Climate and environment-related risks raise new challenges for prudential supervision, said Agnieszka Smoleńska from the Institute of Legal Studies at the Polish Academy of Sciences, and one of the report’s authors, explaining the rationale for mandatory prudential transition plans. These challenges include: the long time horizon of climate risks; the need to use forward-, rather than backward-looking risk management approaches; and a lack of data about the materiality of climate and environmental risks. Prudential transition plans could also help encourage better cross-border and cross-sector cooperation, said Ms Smoleńska.
A three-step approach
To help get such plans up and running, the report suggests three steps that prudential supervisors can adopt.
First, they should set supervisory expectations to ensure plans are fit for purpose and decide how they are to be measured. These could set out, for example, the taxonomies that should be used to determine actions and assess progress, and the inclusion of downstream Scope 3 emissions. Second, the report recommends assessing whether financial institutions are exposed to risks, in the context of alignment with the transition pathways included in various regulations, such as that being discussed under the EU Banking Package. Third, supervisors should act to mitigate acute and significant transition risks indicated in banks’ plans, and could signal any build-up of risks to the market and to policy-makers, says the paper.
A report published last November by the Institute for Climate Economics comes to similar conclusions.
What do experts think?
The data generated by such an approach and the issues that would have to be considered, not least the need to consider credit risk in the longer term, could have “a positive spillover effect” into the wider world’s net-zero transition, suggested the OECD’s Robert Patalano during the webinar.
The transition was “complicated for banks”, commented Laurent Clerc from the French Prudential Supervision and Resolution Authority, speaking in a personal capacity.
“Banks are dealing with moving targets,” he said, emphasising that this increases their exposure to transition risks. To illustrate his point, Mr Clerc gave the example of a bank increasing investments in renewable energy and the danger, if expected technologies failed to emerge, of it being left financing activities out of line with climate targets, which could ultimately turn into stranded assets. Transition risks were “a bit like credit bubble risks”, he said.
Morgan Després, who recently joined the European Climate Foundation, a think tank, after nearly 20 years in the French financial sector, underlined the need for a broader approach to transition plans that involved banks and their clients. Such an approach was important in responding to the UN anti-greenwashing report, Integrity Matters, launched at COP27 in Sharm el-Sheikh, Egypt, last autumn, he suggested, highlighting the need for “proper methodologies and benchmarks” to assess transition pathways.
The current lack of the “right benchmarks” should not be a reason to push back against prudential transition plans, said the Institute for Climate Economics’ Anuschka Hilke. Instead, their adoption by banks would allow supervisors to build up data and mobilise the financial sector to get better tools, she suggested. The idea was two-fold: “to get the financial sector to move and to push the real economy to move faster” towards net-zero, she added.
Over to regulators
The introduction of mandatory prudential transition plans would mean a “steep learning curve” for banks and others, said Ulrich Volz, economics professor at SOAS University of London and one of the report’s authors. “But we have to start somewhere and we hope regulators will take this forward”.
