As each IPCC report provides an ongoing scientific evaluation of the devastating changes taking place to the Earth’s climate, around 160 out of almost 3000 pages were dedicated in this year’s report to the role played by finance in both climate mitigation and adaptation.
The latest IPCC report presents climate change as a systemic financial risk – a considerable breakthrough which asks and mandates for more ambition from financial regulators and supervisors around the world. It highlights how private financial institutions have an incentive to minimise the risk – in a context of moral hazard where taxpayers are likely to pick up the bill when risks materialise, as happened with the 2008 financial crisis. It also strengthens the case that a qualitative, precautionary approach to prudential regulation is needed.
Risk is building up and The Average Taxpayer Will Foot the Bill
In Chapter 6 of the IPCC’s Sixth Assessment report, experts have recognised the systemic nature of climate risk for the financial sector, portraying the magnitude of assets across infrastructure, agriculture, urban and regional centers which are potentially exposed to adverse weather and climate events. In the press conference on the report release, the UN Secretary General Antonio Guterres emphasised in particular the risks associated with fossil fuel investments, warning about the soon to be “stranded assets”.
There are estimates within the report that stranded fossil fuel assets on a modeling of policies to achieve a 2°C target in the long term (until 2050), are currently estimated at an enormous $4 trillion USD in the most conservative scenario. This could go as high as $15 trillion in other scenarios [1]. Beyond that time horizon, the magnitude of stranded assets could increase to astronomical figures beyond these.
The underestimation of climate-related financial risk by public and private financial actors, explains why the current allocations of capital among financial institutions are inconsistent with climate change mitigation objectives.
With inaction, there is a clear line of logic in how taxpayers will be pulled into the equation, with public funds likely to be increasingly used for large scale uninsurable repairs. This could also eventually materialise as taxpayers across Europe and the world, having to bail out ‘too big to fail’ financial institutions, due to their undercapitalised exposures to stranded assets. This is due to the fact that in the absence of impactful regulatory measures, financial actors have an incentive to downplay climate-related financial risk, as well as the fact these risks are not yet reflected in market prices of the assets exposed.
If this continues and policymakers continue to delay device action, systemic risk builds up and eventually materialises with significant disruption to the economy and financial system and at a significant cost for taxpayers.
The Achievable and Available Solutions – Prudential Frameworks
The EU already has a general legal basis to take action, from the Treaty on the Functioning of the European Union, which establishes the precautionary principle as a governing principle in addressing the issues relating to the environment.
There is also a specific legal basis for action in the EU’s Capital Requirements Regulation (CRR) and the Solvency II Directive. These rulebooks are designed to safeguard financial stability and prevent insolvencies of financial institutions. Specifically CRR provides, among other things, for higher risk weightings in situations where the risk of loss cannot be measured precisely even if its occurrence is highly likely.
Risk weighting is part of the Basel model of bank regulation, in which equity capital requirements are applied to banks’ assets after each asset value has been weighted to reflect its risk.
Further to this, the Financial Stability Board also possesses a mandate to assess and address these risks and has been working on supervisory and regulatory approaches for this. In response to a recent consultation on the topic, Finance Watch has recommended holistically and explicitly integrating climate-related risks into existing prudential regulatory frameworks.
This comes in parallel to the principles of the Basel Committee for Banking Supervision, who recently provided its first formal guidance on climate-related financial risks from the global standard-setter and a clear attempt towards consistent supervisory expectations and practices.
Unfortunately, as Finance Watch’s Head of Research and Advocacy Julia Symon has identified, a lack of concrete measures or referenced best practices limit the impact of the Principles in terms of managing climate-related financial risks.
In June, Finance Watch and other partners called for policymakers in the European Parliament to include mandatory transition plans and capital requirements for climate-related risks related to fossil fuel finance in their review of the EU banks and insurers prudential rules.
This would include mandatory transition plans and sustainability targets to achieve the EU climate commitments, backed by governance structures and supervisory review. It highlights how supervised stewardship and engagement through transition planning can help financial institutions reduce exposure to stranded assets, especially as nations head towards the COP 27 summit in Egypt in November.
In the meantime, a number of amendments supporting these proposals have been tabled in the European Parliament for the ongoing review of the bank and insurance prudential rulebooks. The goal is creating a stable, green and transparent economy, one which is more resilient to future economic shocks.
Whether policymakers can step up to this vision, we will have to see.
Ben Cuzzupe
[1] Summary for Policy Makers – IPCC A6 WG III – SPM (Page 37)
