Europe’s regulators push forward on climate risk

The Bank of England has made a big leap forward on regulating climate risk, just days after the DNB published the results of the world’s first climate stress test by a central bank and on the same week that fellow UK regulator the Financial Conduct Authority launched a consultation on green finance.
The Prudential Regulation Authority (PRA), which sits under the Bank of England and regulates banks and insurers in the UK, this week published a draft Supervisory Statement (SS) proposing new guidelines requiring firms to have board-level oversight on climate risk, and evidence of a “credible plan or policies in place for managing exposures”.
The draft SS additionally outlines the regulator’s expectations that firms conduct scenario analysis of “different transition paths to a low-carbon economy” to assess “resilience and vulnerabilities”, and to consider additional climate-related financial disclosures such as those identified in the recommendations of the Taskforce on Climate-related Financial Disclosure.
The consultation period ends on January 15, after which a final version of the SS will be incorporated into the PRA’s existing supervisory framework.
The SS is the culmination of years of work by the Bank of England, which has come out as a leader on climate risk among the central banks. Following on from Mark Carney’s iconic ‘Tragedy of the Horizons’ speech at Lloyds of London in 2015, the BoE conducted a review of the impact of climate change on the UK insurance sector, and last summer turned its attention to the banking sector, publishing the results last month.
David Cooke, a lawyer with environmental law non-profit ClientEarth, told RI that the final SS will “set out expectations for what constitutes compliance with PRA Rules”, although it will not “set absolute requirements”.
“The PRA is making it clear to those it regulates that it considers that they already have obligations to consider climate risk and that it will increasingly expect them to consider climate risk at a strategic level to demonstrate compliance with existing rules on governance and disclosure,” he explained.
“In terms of enforcement action, the PRA has a number of options open to it, including imposing financial penalties, public censures, or suspensions and restrictions on firms and approved persons,” he added.
Another key UK regulator, the Financial Conduct Authority (FCA), which regulates contract-based pension schemes, banks, mutual societies and financial advisors, also took steps forward on climate risk this week, announcing a consultation on its planned approach to climate change and green finance as part of a “joined-up approach to enhance the resilience of the UK financial system to climate change”.
The forward of the document, penned by CEO Andrew Bailey – Deputy Governor at the BoE at the time of its initial efforts on climate change – says the transition to a low-carbon economy “as well as the effects of climate change itself, may have a major impact on financial markets and products”.“We are also seeing increasing consumer demand for ‘green’ financial services products. As this demand grows, questions of green taxonomy (how green products and markets are classified), green disclosure, green performance measurement, and ultimately fairness and consumer protection, will become more important.
“The FCA has a role to play in providing more structure and protection to consumers for these products, ensuring the market develops in a fair, orderly way to meet users’ needs,” he claims.
Beyond the UK, Dutch central bank De Nederlandsche Bank (DNB) last week published the results of a stress-test gauging the domestic effects of a disruptive energy transition – believed to be the first of its kind conducted by a central bank.
The stress test considered the effects of four “severe but plausible energy transition scenarios” on Dutch banks, insurers and pension fund over a five-year period.
Each scenario considered by the DNB is characterised by a shock resulting from (1) the abrupt implementation of policies aiming to reduce CO2 emissions, which pushes up the effective price of carbon to $100 per tonne, (2) technological breakthroughs which double the share of renewable energy in the energy mix, (3) simultaneous implementation of policies and technological breakthroughs, (4) a loss of confidence due to policy uncertainty.
Potential losses across all four scenarios can be “sizeable, but also manageable” concludes the report, claiming that pension funds and insurers face maximum losses of 10% and 11% of total stressed assets, while for banks the figure is lower at 3%.
Last Friday, a group of 18 central banks from all over the world – including those of Germany, England, France, Australia and China – outlined limitations on climate risk assessments, highlighting the quality and availability of data and a lack of understanding of the financial risk differential between “green” and “brown” assets.
The report called for the development of “new analytical and supervisory approaches, including those based on forward-looking scenario analysis and stress tests”.
A forthcoming report due in April – also authored by the group – will aim to reduce the complexity of risk analysis by providing “a small number of high-level scenarios” in line with the TCFD recommendations, clarify the “green” and “brown” asset risk differential and identify areas for central banks to “lead by example”.