The role of regulation in climate change

04 November, 2021Dr Paul Fisher

Financial regulators are getting increasingly involved in climate change. To understand why – and what they might do next – you need to understand their motivation and purpose. Dr Paul Fisher explains.

melting ice caps The over-riding objective of regulators is to protect:

  • the financial system
  • the users who depend on it, and
  • the real economy it supports.

It’s not to protect the financial intermediaries themselves. 

Why the finance sector is different

Unlike other industries, the failure of a financial firm does not simply see business flow to competitors. It engenders mistrust in all similar firms. A single bank failure can cause a run on the banking system. 

And a failure in the supply of financial services can disrupt the real economy through failures in payments, credit availability, insurance etc.

Furthermore, there are good reasons why the users of financial services need special protection. These reasons include information and incentive differences between beneficiary and intermediary such as the co-existence of long-term contracts and short-term rewards for money managers and different awareness of risks. 

There are well-known market failures which a variety of regulators seek to address:

  • prudential regulators, which make sure that key institutions such as banks and insurers operate in a sound and safe manner, and
  • those for conduct, competition, reporting, accounting, deposit insurance, recovery and resolution, pensions etc.

Three reasons why regulators are involved in climate change

Most regulators are established by primary legislation and have specific legal objectives.  Internationally, it is almost unheard of for that legislation to mention climate change, so how is it that regulators are legally involved? 

Climate change is an ethical/moral/social issue about leaving behind a planet fit for future generations. Given the disastrous path of greenhouse gas emissions and global warming, that requires everyone – firm, individual and regulator – to play their role.

Some regulators now have sustainability as a secondary objective. Governments remain the lead authority but, in some cases, have asked their regulators to have regard to climate change when performing their primary duties.

That includes:

  • the Prudential Regulation Authority (PRA), Financial Conduct Authority (FCA) and the Financial Stability Committee (FSC) in the UK
  • European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA) and European Securities and Markets Authority (ESMA) in Europe.

Most of all, climate change represents a material business and financial risk to the financial system, its users, and the real economy.

Climate change is one of the most significant risks on any systemic risk register, for both likelihood and impact. That means that regulators must take it into account, even without any extension to their responsibilities.

However, regulators don’t have explicit responsibility for allocating capital towards socially useful ends. Governments do, as well as the tools: legislation, taxes, subsidies etc. 

And governments are involved in regulation because they make legal rules – such as requiring climate-related financial risk disclosures – and can ask regulators to enforce them.  

Do we need regulators to direct capital to green assets?

There’s no shortage of funds to enable the transition to a net-zero carbon economy.

Rather there’s a regular supply of savings available every year, with beneficiaries who are willing to fund green investments, which are frequently heavily over-subscribed.

The challenge is how to stop financial services from supporting old ‘brown’ industries such as coal production and consumption, when that appears to be profitable in the short-term.

Regulators can, and must, ensure that firms are properly managing risks and disclosing them appropriately. That will help drive capital allocation in a sustainable direction.

In the UK, prudential regulatory intervention has already involved the Senior Managers Regime, co-ordinated stress tests and formal supervisory expectations. Mandatory climate-related risk disclosures have been announced for both the UK and EU. 

Expect regulation to become more explicit, more intrusive, and globally more consistent as the climate crisis bites. But regulators alone can’t deliver what’s required.

In countries where, for example, coal is mainly produced or used (as diverse as Australia, India and Poland) governments will need to lead – to change technology, close down polluting industries, redirect capital and to support individuals who are adversely impacted by rapid economic change.

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