The Developing Regulatory Approach to Climate Change and the importance for Financial Services

19 février 2021

The 2015 United Nations climate change summit in Paris (COP21) saw the first ever agreement under which virtually every country, including the UK, pledged to constrain their greenhouse gas emissions, with the aim of keeping average temperature increases well below 2˚C above pre-industrial levels. Globally, there has been an increasing recognition by central banks and financial services regulators of the potential impact of climate change on financial services markets and the important role that financial services markets have on helping to combat climate change.

In the UK, the Government issued its 25 year Environment Plan in 2018 and, in June 2019, it laid down legislation to reach net zero carbon emissions by 2050. It followed this up with its Green Finance Strategy in July 2019 which recognised the crucial role of the financial services sector in delivering global climate and environmental objectives. In this article, Sushil Kuner, explores why climate change is important for financial services and explains the key climate change related regulatory initiatives underway in the UK.

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Why is climate change important for financial services?

Climate change presents financial risks to various participants in the financial sector. These financial risks arise from two primary channels or 'risk factors': physical and transition risks.[1]

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, 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 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 peoples' retirements and to cover future claims and therefore this presents a significant financial risk to insurers too.

From a prudential perspective, it is clear that climate change has the potential to create significant financial risks which financial services firms need to start identifying, measuring and managing now in order to (a) ensure firms have sufficient capital in place to protect themselves against the threat of climate change and (b) to support an orderly transition to a low-carbon economy.

However, there are also great opportunities in an environment where there is an ever increasing awareness and understanding of the impacts of climate change amongst consumers and investors, with growing demand for greener financial products and services. Studies show that in the US alone, investments into sustainable assets grew by 42% from the start of 2019 to the start of 2020, bringing the total to $17 trillion in total overall, representing a third of all assets under management in the US.[2] This trend is only set to continue with calls from all stakeholders, including governments, regulators, investors, consumers and financial services firms to 'build back better' from the COVID-19 pandemic and build a greener and more sustainable future. COVID-19 has been a wakeup call for many who now realise the impact of immediate financial shocks to their businesses.

Key climate change related initiatives

PRA's Key Focus

In 2019, the PRA published a policy statement (PS11/19) and a Supervisory Statement (SS3/19) setting out its expectations for how banks and insurers should be addressing the financial risks from climate change. Overall it wants the firms it supervises to take a strategic, holistic and long term approach to the integration of climate change into their risk frameworks. In particular, the PRA has emphasised the importance for effective:

  • Governance - a firm's board should understand and assess the financial risks from climate change that affect the firm, and be able to address and oversee those longer-term risks within the firm's overall business strategy and risk appetite. The PRA will expect to see evidence of how firms monitor and manage the financial risks from climate change in line with firms' risk statements, which should include the risk exposure limits and thresholds for the financial risks that firms are willing to bear. There should be clear roles and responsibilities for the board and its relevant sub-committees in managing the financial risks from climate change. In particular, responsibility for identifying and managing financial risks from climate change should be allocated to the relevant Senior Management Function (under the Senior Managers Regime) most appropriate within the firm's organisational structure and risk profile, and the board should be able to evidence effective oversight of risk management and controls.
  • Risk management - in a manner proportionate to their business, firms should identify, measure, monitor, manage and report on their exposure to financial risks from climate change and build these into to their existing risk management frameworks.
  • Scenario Analysis - where appropriate, firms should conduct both short and long term scenario analysis to inform their strategic planning and determine the impact of the financial risks from climate change on their own risk profile and business strategy. This should also be used to explore the resilience and vulnerabilities of a firm's business model to a range of outcomes. Scenario testing will inform firms about the potential impact of the financial risks on their solvency, liquidity and, for insurers, their ability to pay policyholders.
  • Disclosure - banks and insurers have existing requirements to disclose information on material risks within their Pillar 3 disclosures and on principal risks and uncertainties in their Strategic Report (as required under the UK Companies Act). In addition to meeting these existing requirements, firms should consider whether further disclosures are necessary to enhance transparency on their approach to managing the financial risk from climate change. In particular, the PRA has made clear its expectations of firms to disclose how climate-related financial risks are integrated into governance and risk management processes, including the process by which a firm has assessed whether these risks are considered material or principal risks. The PRA expects firms to engage with the framework created by the Taskforce for Climate-related Financial Disclosures (see further below) in developing their approach to climate-related financial disclosures.

FCA's key focus

In its 2018 Discussion Paper on Climate Change and Green Finance (DP18/8), the FCA highlighted the increasing demand for green financial services and green finance products, with the asset/investment management and retail banking sectors leading on the capitalisation of changing consumer needs. At the time, the FCA reported that there were over 70 green bonds listed on the London Stock Exchange in seven currencies, 38 companies had raised $10 billion in London (including 14 renewable investment funds) and the retail banking sector had seen the introduction of green mortgages with home owners who want to buy an energy efficient new-build property being offered lower rates on some mortgages.

The FCA has made clear that, acting within the scope of its responsibilities, it wants to ensure its regulatory approach creates an environment where market participants can adequately manage the risks from moving to a low carbon economy and are able to capture opportunities to benefit consumers. More broadly, it has publicly stated that it wants to help firms and consumers bring about wider societal benefits by accelerating the transition to a net zero emissions economy, consistent with the Government's commitment.[3] Nikhil Rathi, the CEO of the FCA, has stated "we want green and sustainable finance to be at the heart of the continued growth of London as a global financial centre. And we stand ready to support the UK Government to fulfil its commitment to at least match the ambition of the EU Sustainable Finance Action Plan in the UK."[4]

To achieve this, as well as encouraging innovation in the green finance space, the FCA is focused on three key goals[5]:

1. Improving transparency for market participants and consumers

Market participants rely on high quality information to inform asset pricing, risk management and capital allocation. Consumers, too, need clear disclosure from firms so they can choose the right products for them. To that end, the FCA has introduced new climate related disclosure rules within the FCA's Listing Rules to promote adoption of disclosures recommended by the Taskforce on Climate-related Financial Disclosures (TCFD)[6], created by the Financial Stability Board to improve and increase reporting of climate-related financial information.

The TCFD recommendations are wide ranging, covering disclosure of firms' governance arrangements in relation to climate change risks, the impacts of climate related risks on firms' strategies for the short, medium and long term, firms' risk management processes and the metrics and targets used by firms to assess and manage climate related financial risks.

The FCA's new rules require commercial companies with a UK premium listing to include a statement in their annual financial reports setting out:

  1. whether they have made disclosures consistent with the TCFD's recommendations in their annual reports;
  2. where they have:
    1. not made disclosures consistent with some or all of the TCFD's recommendations and/or recommended disclosures; or
    2. included some or all of the disclosures in a documents other than their annual financial report, an explanation why; and
  3. where in their annual financial reports the various disclosures can be found.

The new disclosure rules apply for accounting periods beginning on or after 1 January 2021 and there are expectations that the FCA will extend the rules to a wider scope of listed issuers, potentially tightening the rules and moving from 'comply and explain' to mandatory disclosure. [7]

In November 2020, a cross-Whitehall/cross-regulator taskforce (including the FCA) published a Roadmap charting a path towards mandatory TCFD aligned disclosure obligations across the UK economy over the next five years, with most of the measures to be introduced by 2023. These are set to capture all asset managers, life insurers and FCA regulated pension providers and we expect a consultation paper on this to be issued by the FCA in the first half of 2021.

The FCA recognises that this is just the start and that there is a need to ensure consistency in reporting and comparable information on a global basis. With a set of common benchmarks, standards and metrics for sustainable products, consumers, investors and market participants will be better equipped to assess whether products are genuinely green. It is therefore also supporting plans for a new Sustainability Standards Board, recently proposed by the Trustees of the IFRS Foundation, which would harmonise and streamline sustainability reporting.[8]

2. Building trust in sustainable finance products

With record levels of investment into sustainable assets and issuance of sustainable bonds, the FCA wants to ensure that consumers can trust sustainable products. It therefore wants firms to be clear on their obligations around the design, delivery and disclosure of sustainable products and ensure that consumers receive the right information and advice.

The FCA is particularly focused on 'Greenwashing', i.e. claims that products are green which cannot be substantiated, which could undermine confidence in the green finance sector, leading to unsatisfied demand, reduced participation and competition and insufficient investment in the transition to new zero emissions. The FCA has therefore issued non-handbook guidance to authorised fund managers, in respect of authorised funds, to set out clearly in Key Information Documents if the fund is pursuing ESG or other non-financial objectives and how it does so.

The FCA is also engaging with the European Commission's Sustainable Finance Action Plan (SFAP). As part of the SFAP, the EU Regulation on Sustainability-related Financial Disclosures (SFDR)[9] comes into effect on 10 March 2021 and, in respect of all asset managers, mandates a series of sustainability-related disclosures which must be made in the documentation for a financial product and on an asset manager's website.

There are also a series of new obligations for asset managers, for example, the formulation of sustainability risk policies, where managers of AIFMS and UCITs will need to factor in sustainability risks when complying with existing requirements on investment due diligence and, in respect of MiFID business, portfolio managers will be required to take into account a client's sustainability preferences when complying with existing suitability obligations.

Similarly, the FCA is also engaging with the EU's Taxonomy Regulation[10] which establishes an EU-wide classification intended to provide businesses and investors with a common language to identify to what degree economic activities can be considered environmentally sustainable. As the UK has now left the EU, these rules will not apply in the UK. However, funds marketed into the EU from the UK will need to comply with the SFDR and the Taxonomy Regulations. While it is unclear what the new rules will be in the UK, it is expected that the FCA will aim for minimal divergence in the context of wider aims to create harmonised global standards.

3. Ensuring the FCA provides the right regulatory tools to support firms in the transition to a low carbon economy

The FCA has recognised that close collaboration between regulators and industry is crucial to drive best PRActice and support the transition to net zero carbon emissions. In conjunction with the PRA, it therefore established the Climate Financial Risk Forum (CFRF) which brought together senior financial sector representatives to share their experiences in managing climate related financial risks.

On 29 June 2020, the CFRF published a guide to climate-related financial risk management. The guide aims to help financial services firms understand the risks and opportunities that arise from climate change, and provides support for how to integrate them into their risk, strategy and decision-making processes. The guide contains four industry produced chapters on disclosures[11], innovation[12], scenario analysis[13], and risk management[14].

The CFRF guide is a welcome tool to help firms adjust to new regulatory obligations in tackling climate change and the industry should expect this to lay the foundations for future work by the CFRF as the regulatory strategies in respect of sustainable finance and investments develop.

Concluding remarks

It is clear that firms' responses to financial risks arising from climate change will continue to be a key regulatory priority now and in the future. While banks and the largest insurers have been busy integrating climate related risks into their risk management frameworks over the last few years, the asset management sector should now, if not already, start preparing for the onset of enhanced regulatory obligations.

Firms should not underestimate the amount of work which will be required to comply with new rules and firms marketing funds into the EU should be aware that they will need to comply with the detailed rules within the SFDR and EU's Taxonomy Regulations, including the various Level 2 rules.

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This article has been written for publication in Compliance Monitor.

Footnotes:

[1] BoE and PRA report: "Transition in thinking: The impact of climate change on the UK banking sector", September 2018
[2] hUS SIF Foundation Report on US Sustainable and Impact Investing Trends 2020
[3] FCA's Feedback statement (FS19/6) on Climate Change and Green Finance:
[4] Speech by Nikhil Rathi at the Online Conference hosted by the City of London on 9 November 2020
[5] Speech by Nikhil Rathi at the Online Conference hosted by the City of London on 9 November 2020
[6] Final Report, Recommendations of the Task Force on Climate-related Financial Disclosures
[7] Speech by Nikhil Rathi at the Online Conference hosted by the City of London on 9 November 2020
[8] IFRS Consultation Paper on Sustainability Reporting dated September 2020
[9] Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector
[10] Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088
[11] CFRF Disclosures Chapter
[12] CFRF Innovation Chapter
[13] CRF Scenario Analysis Chapter
[14] CFRF Risk Management Chapter


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