NGFS examines potential paths to climate capital requirements

Central banks could adjust institutions’ capital requirements and buffers based on forward-looking tools such as climate scenario analysis and scrutiny of transition plans, according to new research from the Network for Greening the Financial System (NGFS).

The report, Capturing Risk Differentials from Climate-related Risks, also notes increasing interest among central banks and supervisors in overhauling the industry-wide Pillar 1 capital requirements to better reflect climate risks. The authors say adjusting these requirements based on the “greenness” of assets would require robust evidence demonstrating a risk differential between assets which are green or otherwise, and argue that such data is not yet available.

However, this is more due to a lack of available evidence rather than significant findings to the contrary. Some studies by supervisors have already hinted at such a phenomenon, such as a European Central Bank (ECB) working paper which found that high emissions are associated with higher credit risk for firms. Academic literature reviewed for the ECB study suggests that the higher emissions may result in greater cash flow volatility and uncertainty in return on assets.

There is also research currently underway which may yield more evidence, such as a review being undertaken by the European Banking Authority which is due to publish a consultation paper in the coming weeks. The UK’s Prudential Regulation Authority has identified potential gaps in the current capital framework’s ability to capture climate risks and is investigating the significance of these gaps. It is due to publish an update by the end of 2022.

In the meantime, the NGFS report envisages that supervisors may choose to concentrate on a forward-looking approach.

“Going forward, supervisors could seek to further their understanding of the range of potential risk differentials as manifested through stress testing and scenario analysis, how this could be applied at the individual institution’s level and how this could eventually factor in climate mitigation and adaptation strategies by their counterparties,” says the paper.

“This could also imply using forward-looking tools such as scenarios to set capital requirements and buffers.”

Although the Bank of England (BoE) has said it has no immediate plans to overhaul its capital framework following the results of its first comprehensive climate stress test which were published recently, it has suggested that an overhaul of its capital regime could be on the way. Deputy governor Sam Woods said the BoE is assessing whether current capital levels are sufficiently high to guard against unexpected shocks during the transition to net zero.

Climate advocates argue that implementing climate-adjusted capital requirements via Pillar 1 of the Basel framework is necessary to address the risks that banks’ fossil fuel financing creates for the entire economy.

“The current prudential rules do not take into account the risks that climate change poses to financial stability, which effectively equates to a fossil fuel subsidy and steers the economy into the next financial crisis, which will come on top of the climate crisis,” warned Julia Symon, a senior research and advocacy officer at Finance Watch.