A new report by the UK’s Prudential Regulation Authority (PRA) has explored how to appropriately respond to the risks posed by climate change going forward.
Among the potential options looked at within the report is the possibility for additional climate-related capital charges, in order to incentivize firms to incorporate climate considerations into their business decisions.
Such charges would apply to firms that have significant climate-related financial risk management and governance weaknesses, the PRA explained.
The regulator already uses its supervisory toolkit to ensure that firms develop effective risk management capabilities for climate-related financial risks, and a key part of this toolkit is regulatory capital requirements.
The amount of capital firms are required to hold depends on how much risk they take and create, and the traditional approach to sizing these risks for capital-setting purposes has been to assess historical losses associated with exposures.
But as the market enters into 2022, the PRA plans to switch its supervisory approach on its climate-related supervisory expectations from one of assessing implementation to actively supervising against them.
As climate change becomes part of the core supervisory approach, firms should expect to demonstrate effective management of climate-related financial risks through regular supervisory engagements and reviews, the PRA said.
Where progress is insufficient and assurance or remediation is needed, the PRA will request clear plans and, where appropriate, consider exercise of its powers and use of its wider supervisory toolkit.
“Just as firms must embed our supervisory expectations on climate change, the PRA is also embedding climate change into its supervisory approach from the end of this year,” explained Sam Woods, CEO of the PRA and Deputy Governor for Prudential Regulation at the Bank of England.
“This means that firms will need to demonstrate their ability to understand and manage climate-related financial risks on an ongoing basis, making further improvements with time. As we enter 2022, where firms have not kept pace with our expectations we will stand ready to respond with our supervisory and regulatory toolkit.”
In its report, the PRA concludes that, whilst responsibility and policy tools for driving the transition to net-zero sit with government through setting climate policy and industry through climate action and innovation, the financial sector and financial regulators also have a role to play.
Thus, while regulatory capital may not be the right tool to address the causes of climate change, they should have a role in dealing with its consequences.
That said, further work is required to identify whether changes in the design, use or calibration of the regulatory capital framework are needed to ensure resilience against those consequences.
To help address this, the PRA and the Bank of England will work with international partners, put out a call for research, and host a conference to discuss these complex issues, with the aim of providing more guidance on our approach by the end of next year.
“As we look ahead to COP26 in Glasgow, the financial sector has an important role to play in managing the financial risks from climate change and supporting the transition needed across the economy,” Woods continued.
“In doing so, the financial sector has a unique opportunity to demonstrate the good it can provide in servicing the real economy through a structural change. I look forward to the PRA continuing to play its part in this endeavour.
