EU has the tools to break the climate-finance doom loop

• Download “Breaking the climate-finance doom loop” (pdf 44 pages)

The report calls for immediate regulatory action to end the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability in unpredictable ways. It sets out a legal basis for applying higher risk weights to banks’ exposures to existing and new fossil fuel reserves using prudential tools already available in the Capital Requirements Regulation (CRR). This would dramatically increase the effectiveness of existing regulatory responses, which have so far focussed on transparency, risk modelling and scenario-based analysis.

Thierry Philipponnat, Finance Watch’s Head of Research and Advocacy and author of the report, said:

“The global carbon budget will be exhausted within 10-15 years unless current trends are reversed. We know that climate change will have a significant impact on financial stability but no one can forecast with any accuracy how this risk will emerge. Given the short time available, there is a need for decisive and immediate regulatory action, using prudential tools already available. Policymakers must not wait to assess unquantifiable outcomes before acting to avert financial instability.”

Benoît Lallemand, Secretary General of Finance Watch, said:

“As a number of central bankers have noted, the urgency of the situation calls for less focus on modelling and instead more decisive and immediate action and coordination. The actions we are proposing today are far less radical or costly than those taken in response to the Covid-19 crisis but they target a far bigger threat. They address a disruption risk of another order of magnitude. The good news is that the EU is already empowered and equipped to act. Our new report sets out clear steps that the EU can take now and in the near future to break the climate-finance doom loop.”

Finance Watch’s recommendations to policy-makers:

1. Calibrate the risk weight for bank exposures to existing fossil fuel reserves at 150% in order to make it coherent with Article 128 of the Capital Requirements Regulation (CRR);
2. Calibrate the risk weight for bank exposures to new fossil fuel reserves at 1250% in order to make the financing of new fossil fuel exposures by banks entirely equity-financed to reflect both micro-prudential and macro-prudential risks;
3. Ensure that the modified risk weights are reflected in banks’ internal models for the purpose of calculating capital requirements;
4. Activate Article 459 of the CRR to take immediate action and implement the modified risk weights until banks’ prudential requirements for fossil fuel exposures have been amended in CRR;
5. Amend the risk weights for banks’ existing fossil fuel exposures in Article 128 of CRR and for banks’ new fossil fuel exposures in Article 501 of CRR;
6. Promote the adoption of similar prudential requirements globally by engaging the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB).

ENDS

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NOTES FOR EDITORS

The Bank for International Settlements and the Banque de France recently warned that climate change threatens to provoke “green swan” events that could trigger a systemic financial crisis unless authorities act against such risks: “The deep uncertainties involved and the necessary structural transformation of our global socioeconomic system are such that no single model or scenario can provide a full picture of the potential macroeconomic, sectoral and firm-level impacts caused by climate change. Even more fundamentally, climate-related risks will remain largely unhedgeable as long as system-wide action is not undertaken.” (Bolton, Després, Pereira da Silva, Samama, Svartzman “The green swan – Central banking and financial stability in the age of climate change”, January 2020).

Given the radical uncertainty of climate-related financial risks, the UCL Institute for Innovation and Public Purpose argued that ‘efficient’ price discovery is not possible and proposes a ‘precautionary’ policy approach: “Since climate change poses a severe and potentially irreversible threat, lack of scientific certainty as to its exact nature or timing should not prevent regulatory action to mitigate its impact.” (Chenet, Ryan-Collins, van Lerven, “Climate-related financial policy in a world of radical uncertainty: Towards a precautionary approach”, December 2019).

A new study by the financial thinktank Carbon Tracker Initiative estimated that the COVID-19 crisis is now accelerating a trend of falling demand, lower prices and rising investment risk which is likely to slash the value of oil, gas and coal reserves by nearly two thirds, i.e. $25 trillion, increasing the risk and likelihood of stranded assets. The looming fossil fuel collapse could pose “a significant threat to global financial stability” by wiping out the market value of fossil fuel companies (“Decline and Fall: The Size & Vulnerability of the Fossil Fuel System”, 4 June 2020).