Banks hold capital to cover their losses and provide confidence to investors and lenders that they are viable and sustainable businesses. The amount of capital they hold is determined by the risks they face and the prudential regulatory framework within which they operate.

Increasingly, climate-related risks can give rise to losses. Extreme weather events such as droughts, flooding or fire can have a disastrous effect on agriculture, businesses, and people, causing significant loss. Some coastal cities such as Jakarta or Venice are slowly, or even rapidly, sinking and within decades large areas may be uninhabitable. Those affected may struggle to service or repay loans; property, capital and investment instruments may see valuation falls, and collateral values may be insufficient.

Even business not directly affected by climate change can experience detrimental knock-on effects including disruption to their supply chains or customers, which not only affects their ability to provide or sell their products and services but can also lead to extra costs to source replacements. 

These climate changes will continue in the future and may accelerate. It is also likely that areas unaffected today will be affected adversely in the future.

At the same time, there are transition risks with the move towards a less polluting, greener economy. Government policy and regulation designed to reduce consumption of polluting products – for example, rules to stop the sale of new petrol and diesel cars from 2030 – will have a dramatic impact on profitability or income streams and potentially increase the credit and market risk of lending to or investing in these products and markets. Shifts in public attitude may also affect future demand for products, as the recent growth in electric cars shows.

The phasing out of fossil fuels will have a massive impact on lending or investing in the gas and oil extraction and coal mining sectors, not to mention any derivative products.

The move to a low carbon economy also presents opportunities for new climate change markets and solutions, but they need financing. “Climate change solutions are an essential part of the move toward the low-carbon economy,” says Rebecca Self, former CFO Sustainable Finance, at HSBC and now Founder and Managing Director of Seawolf Sustainability Consulting. “Currently they often lack mainstream finance due to their different risk and return profile, when compared to existing technology”.

The need for finance for the many new and innovative products and services is not without risk. While some will succeed, with potentially good rewards, others will fail. The credit risk of new start-ups is typically higher, and any losses are normally borne by the finance providers, which can be a deterrent to financing. The challenge is to ensure real and beneficial solutions can emerge. 

Losses are captured and capitalised in various ways in the prudential framework; whether that’s expected losses calculations, risk weighted assets to capture the potential unexpected losses, or stress and scenario tests that explore and capture the effects of future shocks including climate related events. 

A feature of these different approaches is that the past typically forms a significant part of the methodology to calculate the loss estimate and capital requirement. The calibration of risk weights often based on historical data about actual losses or credit events, while the design of stress and scenario tests is likely to be constrained to some extent by prior experience of events and the relationships that existed between variables. 

The risk is that while some climate-based losses will be captured in past data, many will not. Even where there is past data, climate-derived losses may not represent a sufficiently rich data set (by volume and length of time series) to accurately determine a capital requirement.

The data may also not be representative of future losses, bearing in mind it cannot be said with any certainty how climate risks may evolve. A further issue is that there may be challenges in separating out climate-based losses from other drivers of loss, due to a lack of granularity in banks’ methodologies. 

As the importance of climate change increases, new methodologies to identify, assess and measure the risks will evolve. Some risks such as houses built on flood plans that are seeing an increased propensity for flooding, may be measurable now. 

The capital framework has a short-term time horizon; one year for IRB models and three to five years for stress tests. Bearing in mind the effects of climate change are a much longer term – the Government’s strategy is to meet its net zero target by 2050 - this disconnect may not be too much of a capital risk if a bank’s exposures are typically shorter term.

There may however be other issues that banks need to address. As markets and products change, banks’ front office practices, risk management and governance arrangements need to be able to adapt, assess, measure, price and manage new risks to ensure the bank remains viable going forward. 

There is also the need to guard against the “Tragedy of the Horizon”: a term coined by Mark Carney when Governor of the Bank of England, that reflects on the effects of climate change being beyond the time horizon that most people operate to. The risk is that remedial action is left too late to avoid the adverse effects. As the Bank of England’s recent report on climate-related risks and the regulatory capital framework notes in its first key finding: “Existing capability and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses”. 

The challenge facing regulators is how best to respond. There are a number of questions that need to be considered, including how the potential for climate losses should be captured in the micro and macro prudential frameworks, how gaps in past data should be dealt with, and how best to manage the risks and required changes in a dynamic environment? The Bank of England’s report recognises that “Substantial further work is needed and there remain many open questions”, which it will look to address.

Question marks also remain over how long the regulators have to potentially amend their methodologies and whether the evolution of existing approaches will be enough or whether significant regulatory intervention will be required.

It has been suggested that prudential capital rules should be used to incentive financing of green assets, that is those that help reduce or eliminate climate change. This could take the form of reduced capital requirements (lower risk weights) for green assets, or higher capital requirements (higher risk weights) for non-green assets.

The risk weights would not reflect the actual credit and market risks of lending. But by changing the relative costs of green and non-green assets and the risk-reward trade-off, banks would be incentivised to lend to green assets. 

Although Self believes “the purpose of the prudential framework is clear”, it is not without potential downsides. “It is possible it has an unintended consequence of maintaining lending to and investment in carbon industries and does not incentivise adequate investment in sustainable innovations by new players”. 

A measure in the Financial Services and Markets Bill currently before Parliament provides a basis for doing this. The measure will require regulators to have regard to “the need to contribute towards achieving compliance with section 1 of the Climate Change Act 2008 (UK net zero emissions target)” when undertaking their functions.

Indirectly, a December 2022 letter from the Chancellor of the Exchequer to the Governor of the Bank of England, setting out HM Treasury’s recommendations to the Prudential Regulation Committee, says the PRA should “have regard to supporting the government’s ambition to encourage economic growth …including the government's ambitions for the provision of sustainable finance and the supply of long-term investment to support UK economic growth…” 

There is precedent for reducing risk weights to achieve a particular lending outcome. As described in CP 16/22 (Implementation of the Basel 3.1 standards), a lower risk weight for SME lending was “originally introduced to limit disruption to the flow of credit to small businesses during the phase-in of stricter requirements following the 2008 global financial crisis”. While originally a transitional measure to appropriately manage a smooth transition between changing regimes, it did nevertheless gain permanence in the capital rules.

The principal risk of a reduction in risk weights is that it results in lower capital requirements, which leads to a bank holding insufficient capital for the risks it runs. For example, a house built with heat pumps and solar panels may be green, but if it’s built on a flood plain, it carries a heightened risk from climate change. Lower risk weights would undermine the general and principal objective of prudential supervision.

The flip side is whether there is a trade-off and that lower risk weights lead to a greater and more stable supply of financing for the affected sector. If the regime is implemented for diversified banks with small concentrations to green assets, undercapitalising those assets should not threaten the bank as a whole. The potential losses are effectively subsidised by the bank’s other businesses. This does, however, distort the level playing field. 

The use of higher risk weights to penalise non-green assets increases capital and would support individual bank safety and soundness. However, an increase in the cost of lending may push that lending into the shadow banking realm, where the scrutiny of environmental and social issues may be much lower. In that sense it would not achieve the desired aim and may even be detrimental. 

There is also a risk that this approach becomes a dangerous precedent for pursuing other public policy goals, which may be inconsistent with and undermine the prudential regulator’s primary objectives. 

There are also practical challenges in designing an effective regime, not least the absence of a UK taxonomy to clearly define those assets that help reduce climate change. Some green assets are obvious such as those that offer sustainable alternatives (solar and wind farms), But others will reduce greenhouse gas emissions by varying levels, while others may continue to generate or even increase emissions in pursuit of the development of green products. That’s also assuming that the definition of “green asset” remains constant.

The absence of a UK taxonomy suggests that in the first instance any regime would likely be narrowly targeted at clear and obvious green assets such as windfarms. However, the downside is that it might fail to provide adequate incentives for new innovative assets that are yet unproven. Essentially, existing green assets benefit at the expense of longer-term and potentially more effective solutions.

With some non-UK taxonomies that currently include gas as a green asset, there is potentially no climate benefit if lending on gas assets is promoted. There may even be an increase in climate risk on the balance sheet, but for less capital held. 

Green assets are only one aspect of the sustainability agenda. To be truly sustainable, incentive schemes should also take account of the effects on biodiversity or society, where trade-offs may exist. A sea-based windfarm generates sustainable electricity, but its construction may damage the seabed. Cobalt, a key component of rechargeable batteries, is mined, often illegally, in hazardous conditions and using child labour.

The complexity of a coherent capital framework that addresses these different outcomes and looks to manage their potential trade-offs while at the same time delivering on its primary aim of prudential soundness cannot be underestimated.

There are also alternative and arguably better approaches to the prudential regime. Whereas the remit of prudential regulation covers only a part – albeit a significant chunk – of the economy, the Government may be better placed to deliver an economy-wide solution.

For example, the Government could grant subsidies or turn to tax in the form of tax breaks or impose a carbon tax to promote lending and investment. An ecocide law would be another option. Government measures may also improve the creditworthiness of green assets and reduce the risk of lending to new innovative solutions. 

Regardless of the prudential capital rules, banks are taking action and new approaches are afoot – for example BPCE has a program to decarbonise its balance sheet and align with the Paris agreement. Or HSBC's climate strategy notes “ …we’re working with our clients to help them reduce their emissions and scale up low-carbon solutions, as we work to reduce our own”. 

However, regardless of the mechanisms that may emerge, the PRA’s 2021 Climate Adaption Report warns that “in the context of the PRA’s and the Bank’s objectives, the regulatory capital framework is not the right tool to address the causes of climate change (greenhouse gas emissions).

Research shows that the use of capital requirements as a tool to affect financing and investment decisions directly is not likely to be effective unless calibrated at very high levels,” the report warns. “These levels could give rise to unintended consequences, such as the erosion of capital in the system or build-up of risks in other areas. Ultimately, regulatory capital cannot substitute for government climate policy.”