The crucial role of Financial Services in the transition to Net Zero

17 GERMAN minute read
09 November 2021

Over the past few years, there has been an increasing global recognition by central banks, governments and financial services regulators of the potential impact of climate change and the crucial role the financial services industry has in helping combat climate change. Ahead of COP 26, the UK's Financial Conduct Authority (FCA), Prudential Regulation Authority (PRA) and The Pensions Regulator (TPR) published their Climate Change Adaptation Reports[1] which set out how climate change affects their respective responsibilities and the actions they, and the financial sector, are taking in response to both the financial risks and opportunities arising from climate change.



What are the financial risks and opportunities from climate change?

Climate change presents financial risks to various participants in the financial sector. The Bank of England (BoE) and PRA reported in September 2018 that financial risks from climate change arise from two primary channels or 'risk factors'; physical and transition risks.

Physical risks arise from climate and weather-related events, such as heatwaves, droughts, floods, storms and sea level rise. For banks, they can potentially result in large financial losses, impairing asset values and the creditworthiness of borrowers. Insurers may face a higher number of more costly claims due to an increased frequency and severity of major weather events and for the asset management sector, climate change may materially reduce investment values, a particular concern in the pensions sector.

Transition risks, on the other hand, can arise from the process of adjustment towards a low carbon economy. Changes in policy, technology and sentiment could prompt a reassessment of the value of a large range of assets and create credit exposures for banks and other lenders as costs and opportunities become apparent. A sharp repricing of assets could also harm investors if the transition to a low-carbon economy is not smooth. Insurers are responsible for investing billions of pounds of assets which need to grow to fund people's retirements and to cover future claims and therefore this presents a significant risk for insurers too.

However, with an ever increasing awareness and understanding of the impacts of climate change amongst consumers and investors and growing demand for greener financial products and services, there are great opportunities for the financial services sector to accelerate the transition to a net zero emissions economy. As pointed out by Nikhil Rathi, the CEO of the FCA, during his speech at COP26 on 3 November 2021, the global market for green debt is growing with issuance being at $375 billion in the year to end September 2021, responsible investment funds now accounts for almost 40% of net UK retail fund sales last year and the Government has recently raised £16 billion in its first two green gilt transactions.

So what are regulators doing to ensure the smooth transition to net zero?

The FCA, PRA and TPR have all made clear their roles in the transition to a net zero economy through their respective Climate Adaptation Reports.

PRA

The PRA has linked its work on climate change to its primary statutory objective to promote the safety and soundness of the firms it regulates. Its main focus is to manage material financial risks created by climate change, therefore aiding a smooth transition to net zero; an orderly transition will minimise not only the risks to the climate but also the future financial risks faced by firms and the financial system.

The PRA largely views its role in the net zero transition as a supervisory one. In April 2019 it issued the world's first supervisory expectations for the management of climate-related financial risks ("SS 3/19")[2]. This statement created a comprehensive set of expectations for how banks and insurers should manage the financial risks arising from climate change, which can be summarised as follows:[3].

  1. embedding climate-related financial risks into firms' governance frameworks;
  2. under the Senior Managers Regime, allocating responsibility for identifying and managing climate-related financial risks to the relevant existing Senior Management Functions (SMF) and ensure that these responsibilities are included in the SMF's Statement of Responsibilities;
  3. incorporating climate-related financial risks into existing risk management frameworks;
  4. undertaking longer-term scenario analysis to inform strategy and risk assessment; and
  5. developing an appropriate approach to climate disclosure in line with the framework of the Task Force on Climate-Related Financial Disclosures (TCFD).

In its Adaptation Report, the PRA concludes that firms have made tangible progress against the SS 3/19 expectations but that some firms are materially more advanced than others, and there is still much further to go.

A major discussion point in the PRA's report is the analysis given to the current regulatory capital framework, which helps to ensure that firms have sufficient resources to absorb future financial losses, and whether it is suitable for future climate-related financial risks. Whilst there is scope for current capital requirements to address these risks, the relatively un-trodden path of climate-related risk poses questions around the framework. Going forward, the PRA will be considering whether enhancements are required to regulatory capital regimes, setting out future plans for climate scenario analysis and reviewing firms' transition plans to understand the implications and progress of these plans at a firm and financial system level.

FCA

The FCA's Adaptation Report sets out the FCA's approach to the fight against climate change through the prism of its three statutory objectives; consumer protection, market integrity and effective competition in the interests of consumers. On consumer protection, the FCA is aiming to ensure that consumers are able to access green products and services that fit their needs and preferences. The FCA has made clear that providers must ensure that such products and services work as expected, and consumers are not misled. To that end, it has badged 'Greenwashing' as a material risk and expects firms offering green products and services to ensure that their design and delivery match their marketing and reasonable expectation of consumers.

Transparency is also key to maintaining market integrity, with the FCA stating that all investors need good disclosures in order to inform their decisions and manage climate-related risks and opportunities. This supports effective price formation in the markets and the efficient allocation of capital.

In terms of effective competition, the FCA is attaching great importance to innovation which will help ensure that consumers' needs and preferences can be met as we move towards a more sustainable future and which drives competition to develop more sustainable solutions.

In light of the above, the FCA has set the following outcomes it wants to achieve:

  • high-quality climate and sustainability related disclosures to support accurate market pricing, helping consumers choose sustainable investments and drive fair value - it has already established new 'comply or explain' climate related financial disclosure rules aligned with the TCFD recommendations[4] for premium listed issuers[5] and has set out proposals to widen the scope of these rules to capture a wider range of listed issuers and the asset management sector;[6]
  • promote trust and protect consumers from misleading marketing and disclosures around ESG-related products - the FCA has issued a discussion paper seeking views on new sustainability disclosure requirements for asset managers and FCA regulated asset owners, as well as a new classification and labelling system for sustainable investment products to build trust in the market, improve transparency for consumers and better meet the needs of institutional investors and other stakeholders;[7]
  • regulated firms have governance arrangements for more complete and careful consideration of material ESG risks and opportunities;
  • active investor stewardship that positively influences companies' sustainability strategies, supporting a market-led transition to a more sustainable future;
  • promote integrity in the market for ESG-labelled securities, supported by the growth of effective service providers - including providers of ESG data, ratings, assurance and verification services; and
  • innovation in sustainable finance, making use of technology to bring about change and overcome industry-wide challenges.

The FCA also recognises the role of capital mobilisation in financing both climate change adaptation and climate change mitigation. The FCA states that financial services have a central role to play in the transition to net zero and adaptation as they help capital owners choose suitable investments. Providers of financial services guide those choices by supplying appropriate information to investors. Consequently, providers have a chance to channel funds towards green initiatives, not only enabling the UK to meet its net zero target, but also allocating capital efficiently to businesses that are adapting well to climate change. Further, they state that the financial system also needs to help and supervise emissions-intensive sectors by providing finance and risk management solutions which support firms in amending their business models in a way that aligns with transition.

TPR

TPR's climate change strategy aligns with its corporate strategy, where its work on climate change sits under its strategic goal of ensuring that decisions made on behalf of savers are in their best interests. It recognises that climate change is systemically significant to pensions, its own regulatory regime and its statutory objectives which include the protection of member benefits, the reduction in calls on the Pension Protection Fund and the promotion of good administration of schemes.

TPR's report strikes a more sombre note than both the FCA and PRA reports. It acknowledges that there is significant work to be done by pension schemes in light of its findings that only 43 percent of Defined Contribution ("DC") schemes considered climate change in their investment strategies, and more than half of Defined Benefit (DB) schemes had not allocated time or resources to assessing climate-related risks or opportunities.

All regulated schemes are exposed to climate related risks (both physical and transitional) through their investment arrangements. TPR therefore believes that it can aid schemes in assessing and addressing these risks through its regulatory approach, including by:

  1. Setting clear expectations - TPR will publish guidance on the recent climate change regulations under the Pension Schemes Act 2021 (the PSA) that clarifies what it will be looking for from schemes as they assess, manage and prepare to report in line with the TCFD recommendations. It also intends to work with the Department for Work and Pensions to share best practice examples from TCFD reports.
  2. Identifying risk early - Once schemes start reporting as required by the regulations under the PSA, TPR will carry out a thematic review on scheme resilience to climate-related scenarios with a view to using the findings to inform any revisions to its guidance.
  3. Driving compliance through supervision and enforcement - TPR commits to using its supervisory role to encourage trustees to focus more attention on climate change when selecting investments, discussing covenant and working with their advisers.

What's next?

For all three regulators, Greenwashing by financial market participants and issuers is a significant threat to the Government's aims to achieve net zero carbon emissions by 2050.

As such, the UK Government has committed to implementing a UK Green Taxonomy to provide a shared understanding of which economic activities count as 'green' and has made clear in its recent Green Finance Paper[8] that HMT and the FCA are exploring how best to introduce wider sustainability-related disclosure requirements for corporates, asset managers / owners, investment products and financial advisors. While the details of disclosures for financial advisors are subject to further consideration, the key aim here will be to ensure that sustainability matters are taken into account in investment advice.

One thing is clear, accelerating a smooth transition to net zero is a key priority for each of the UK financial regulators who are clearly gearing up their regulatory scrutiny towards different financial market participants.

Footnotes

[1] Joint statement by the FCA, PRA, TPR and FRC on the publication of Climate Change Adaptation Reports
[2] Enhancing banks' and insurers' approaches to managing the financial risks from climate change
[3] See our article entitled 'How will climate change impact the financial services sector?' published in September 2020 which details each of these focus areas
[4] The TCFD Recommendations introduce new climate related financial disclosures relating to governance, strategy risk management and metrics / targets in managing climate related risks and opportunities.
[5] See FCA Policy Statement 20/17
[6] See FCA Consultation Paper 21/17
[7] See FCA Discussion Paper 21/4
[8] Greening Finance: A Roadmap to Sustainable Investing


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