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Capital risk, climate change and regulation

04 January, 2022Paul Howard
Factory chimneys with green smoke

Paul Howard gives an overview of the PRA’s current thinking on managing climate-related financial risk. He examines what bank boards and senior managers should look out for, including climate risks in supervisory assessment, ESG skills and the capital framework.

One paper that every bank risk professional should read is the Prudential Regulation Authority’s (PRA’s) Climate-related financial risk management and the role of capital requirements.

Published in October 2021, it runs to over 50 pages over two parts.

The first covers the regulator’s assessment of climate-related risks and the proposed supervisory approach in 2022. The second section focuses on macro prudential matters. In particular, it discusses the current thinking on using the regulatory capital framework to support the ‘green’ direction of travel.

I say current thinking as this is new territory for everyone. Helpfully, the paper explains the regulator’s thought processes in arriving at its current conclusions. But the lack of precedent means there may be a need to adjust course as experience and knowledge grow.

There are three key takeaways for now.

1. Climate risks and the formal supervisory assessment

Supervised firms – more specifically the designated senior managers – will be asked to prepare a report for supervisors on how they have embedded the management of climate risk in their existing risk management frameworks.

“Where progress remains insufficient” the PRA is prepared to resort to  its wider supervisory toolkit including risk management and governance scalars (see point 3).

It could also implement a Skilled Persons Review under Section 166 of the Financial Services and Markets Act 2000. That is currently a nuclear option, but it may become less rare for the reasons given below.

2. The regulator is tackling the issue of ESG skills

The regulator warns that board and senior management competence in managing ESG risks will be evaluated. It says, “Firms need to hire and build executive knowledge and capabilities on climate-related risks and ensure that the board is well equipped for such discussions.” 

The problem for any board in dealing with new and fast-changing topics is having enough knowledge to effectively challenge information. Bank boards have deep expertise on finance. They tend to know a lot less about, say, biodiversity.

But doing nothing is not an option. That means there is a major unmet need for director and senior management training in tackling ESG-related risk and governance.

3. The capital framework and climate change

The regulatory capital approach to ESG is still evolving, but there is one early conclusion that should be noted – “capital can be used for the consequences of, but not the causes of climate change.” 

What does this mean?

The thinking is that regulatory capital requirements aren’t an effective way to shape the financing decisions of banks and that amending capital regimes can have far-reaching and unintended consequences.

So, there will be no attempt to use the capital framework to address greenhouse gas emissions.

“Ultimately, regulatory capital cannot substitute for government climate policy,” the regulator notes.

The regulator does think, however, that the capital framework can be used to “provide resilience” against the financial consequences of climate change.

Capital and Climate Conference 2022

The regulator’s research so far is focused on the use of buffers and where the risks may be captured in Pillar 1 or 2. The rationale and shortcomings for the various approaches are discussed.

There’s also exploration of the balance between an internationally driven Pillar 1 approach and a more domestic Pillar 2 approach. To complement the internal work in this area the regulator will put out a call for papers and host a Capital and Climate Conference in Q4 2022.

All in all, watch this space.

The Governor of the Bank of England, Andrew Bailey, in a speech on 3 November, doubled down on the enforcement points made in the PRA paper. He also said that the bank would be sharing details of climate risk assessments in 2022.

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