The Bank of England (BoE) Climate and Capital conference brings together central bankers, financial regulators, industry experts and academics to consider issues associated with adjusting the UK’s capital framework to take account of climate-related financial risks.
Discussions will focus on the appropriate time horizon over which climate risks should be reflected in capital requirements, and whether requirements should be set on a microprudential firm-specific basis or applied at a macroprudential system-wide level.
Follow this page for updates on the speeches, discussion and developments throughout the day.
Woods: BoE has a ‘completely open mind’ on capital frameworks
Deputy governor Sam Woods gave a welcome address, noting that over 1200 people were taking part in the event, with a significant proportion joining from overseas.
He said the BoE understands that climate change could be a major risk to financial stability, highlighting steps the bank has taken to integrate climate consideration into its supervision – an approach which has now become “business as usual”. He said the bank ran an exploratory scenario which helped build its understanding on the issue.
But the BoE’s actions so far have left Woods and his colleagues with a big question: “do our capital frameworks adequately cover climate-related risks?” He said they currently have a “completely open mind”.
Woods raised the issue of where climate factors are best addressed in the capital framework. He pondered: “Is it a pillar 1 or pillar 2 question? A microprudential or macroprudential question? What is the appropriate time horizon?”
He acknowledged the potential disconnect between the relatively long time horizon the BoE uses for scenario analysis and the relatively short one used to calculate capital requirements. He said there is uncertainty about how to capture climate-related risks, but questioned whether this is sufficiently different from the types of uncertainty in other areas of risk to necessitate a completely new approach.
Woods stressed that the BoE is keen to contribute to international standards and expressed a hope that the conference would inform debate elsewhere. He confirmed that the bank will publish an update on its thinking “in due course”. The PRA has previously suggested it will finalise new guidance by the end of 2022.
Stern: ‘If we fail to deliver, the consequences will be immense’
Nick Stern, chair of the Grantham Institute at the London School of Economics, also gave a welcome address. He highlighted the need to grapple with the “pace and scale” of the net-zero transition, warning of the severe consequences of any delay.
“This is public policy as if time matters,” he said.
Stern welcomed the agreement at Cop26 in Glasgow to keep carbon emissions at 1.5C, saying that the percentage of the population exposed to extreme heat is 14% in a 1.5C scenario and 37% in a 2C scenario.
He said action in the coming decade will be decisive, and warned that despite the current focus on energy security following Russia’s invasion of Ukraine, investors should avoid committing to new fossil fuel projects which create assets which become stranded in a few years’ time.
Stern said he and his colleagues have calculated that the global energy transition requires an increase in investment of around 3% of GDP. But he argued this will assist the global economic recovery, and is eminently feasible given that planned savings are currently far in excess of investment. He said meeting such a target would merely take investment back to the levels of 15-20 years ago.
He suggested that emerging markets and developing countries will have to make greater investments, predicting that China’s upcoming 15th five-year plan will focus on green growth as the primary driver of growth.
Stern argued that developed countries will have to transform and transition their infrastructure in different ways, focusing on cities, energy, transport and land. He stressed the need for public policies which enable investment and “foster investment of the right kind”.
Stern spoke about the need for public policy to create the confidence for investment to take place. He said multilateral development banks will help “set the right frameworks and provide the right instruments”. He argued that international coordination will reduce risk, since investors will feel more confident if they see many countries going in the same direction.
Concluding his remarks, Stern again stressed that policymakers should establish a route from climate to capital for banks and insurers with an understanding of the pace and scale of change required. Systemic transformations are “not simply nice to have but necessary to deliver on the targets that the world has set, and where the UK has been as a leader,” he said. “If we fail to deliver, the consequences will be immense for the world as a whole.”
Responding to an audience question about whether there is a trade-off between the need to increase investment and asking firms to hold more capital, Stern reiterated his argument that investment overall is too low at a macro level. “It’s the balance between savings and investment that’s the key flow in all of this,” he argued.
Another questioner asked about the implications of the ongoing energy and food crises, and Stern reiterated his point that decisions made now to boost energy security must not create new risks down the line. He pointed out that fossil fuel exploration usually takes at least 8-10 years to produce new output, by which time countries’ additional energy needs will increasingly be met by renewables and other sources.
Fed’s Stiroh presents climate capital framework
Introduced and moderated by Nicholas Stern, the second session of the day focused on understanding the conceptual route from climate change to capital for banks and insurers.
The Federal Reserve’s Kevin Stiroh, senior advisor for supervision and regulation, was the first speaker, giving an overview of his recent paper on a “stylised, non-country-specific framework to assess conceptually how the financial risks of climate change could interact with a regulatory capital regime”.
Stiroh began by explaining that, aside from looking at how climate change could impact the capital framework, it is also important to examine the assumptions and beliefs needed to support alternative policy conclusions. Reviewing different views of capital in absorbing unexpected losses, he emphasised that he would be speaking only on traditional risk perspectives, and not on measures designed to mitigate climate change.
Stiroh then introduced the components of his capital framework, consisting of five variables along with their policy objectives. His approach involves focusing on the loss generating processes, along with their impacts on each component of the capital framework, but he also stressed the substantial challenges involved, including a lack of clarity on how loss-generating processes might change for banks as a result of climate factors. Other issues include multiple policy objectives and mandates, and the complexity of the regulatory capital regime.
Focusing on loss-generating processes, Stiroh distinguished between the mean and variance of potential losses, with an increase in the mean resulting in higher expected losses and a variance increase resulting in higher unexpected losses. However, he again emphasised the significant uncertainty in how these losses might materialise.
Stiroh then looked at the assumptions underlying the elements of his capital framework, along with examples of their potential impact, before noting there are many questions yet to be answered.
He concluded by saying that climate change could impact the regulatory capital regime, but that this impact would depend on assumptions and beliefs about how climate change would change the loss generating process, and on the policy objective involved.
Climate change poses risks for insurance as well as banks
Next up was the BoE’s executive director of prudential policy Vicky Saporta who discussed on the insurance industry. Saporta began by reviewing the work of the International Association of Insurance Supervisors – of which she is also chair – on climate change, including its 2021 paper on the supervision of climate-related risks in the insurance sector and a special edition of its Global Insurance Market report focusing on climate change. Her presentation was also informed by a series of workshops on climate scenario analysis held with over 200 insurance supervisors.
Saporta reviewed the similarities and differences between the ways climate risk is represented on bank and insurer balance sheets. Climate change is a source of financial risk for both, she said, and both are similarly affected on the asset side. However there are also important differences, as bank deposits are not a function of climate risk and bank valuation is determined mainly by accounting. In contrast, climate change affects the liabilities of insurers, with valuation more affected by regulators.
Saporta then examined both the expected and unexpected losses to insurers from climate change, concepts that are familiar to the insurance industry. Examining the capital requirements for both banks and insurers, she also pointed out that there is no explicit role for buffers within insurance frameworks. She concluded by looking ahead, focusing on the need for discussion on the appropriate time horizon and the uncertainties involved.
A period of ‘creative destruction’ is inevitable, says Stern
Stern began the question and answer session by looking at the scale of the challenge, saying “we have to act as if the mean and the variants of losses are both going up”.
“We know that we’re going to have to go through a very rapid period of structural change,” he went on, calling this a process of “creative destruction” that has perhaps not been seen since the second world war. Stern asked Stiroh and Saporta if they agreed with his assessment and, if so, what the role of governments and public policy institutions should be in furthering an orderly transition.
It’s “totally reasonable” to believe that mean and variant losses are going up, Stiroh replied, but stressed it is also important to ask “by how much?” Other important questions include how much these risks are already accounted for under existing forward-looking frameworks and approaches, and what the tradeoffs might be to using capital requirements for climate goals. In terms of the role of public bodies, Stiroh pointed to the Basel Committee’s recently released principles for the effective management and supervision of climate-related financial risks.
Saporta agreed that, if there is no adjustment of balance sheets in response to climate risks, it is reasonable to expect losses to increase. This means that, in the absence of adjustments, higher loan loss reserves and provisions for banks, higher technical reserves for insurers and, ultimately, higher capital requirements, she said. Prudential regulators need to protect institutions against the consequences of these climate risks, she added.
Turning to audience questions, the speakers were asked how climate risk might be hedged by banks. Stiroh said that such transference of risk can mitigate some risks, but can also be an amplifier if the risk is not fully understood or appropriately priced. Saporta agreed, referencing the BoE’s experience with its climate scenario analysis exercise for banks.
Asked if the capital regime should be the same in different countries, Saporta said that “if the loss generating processes are the same, then yes”. Stiroh said the impacts would differ according to the structure of the economy, regional climate variations and differing potentials for adaptation.
Another question concerned the potential for climate transition risks to interact with and amplify the economic cycle, leading to a “bumpy ride” similar to that experienced since the Russian invasion of Ukraine and requiring counter cyclical capital buffers. Stiroh said this was an excellent example of the complexity involved, pointing to scenario analysis as a useful tool for understanding these risks. Stern agreed, giving the example of how China’s drought reduced hydroelectric capacity and prompted a return to coal.
Wrapping up the discussion, Stern said it is clear that supervisors and regulators have moved “way beyond” the question of whether they should engage with climate risk to the question of how to do so. “As we go more deeply we recognise how important it is, but also that it is not simple,” he concluded.
Is climate risk a micro or macroprudential issue, or both?
The final session of the day addressed the question of how and whether climate-related financial risk should be reflected in microprudential and macroprudential frameworks.
Alison Scott, a director of the PRA, opened the discussion by clarifying that the agency does not see capital as an appropriate tool to address the causes of climate change, although it has an open mind as to how it may be used to better mitigate climate-related financial risks. She said she and her colleagues are still in the “foothills of policymaking”, and that there is a need to fully understand how climate is captured by the current frameworks before considering adjustments.
Ben Guin, a senior economist on prudential policy at the BoE, presented research exploring whether it is possible to find a differential between green and dirty assets in the mortgage sector. He explained that he and his colleagues had studied the energy performance certificates (EPC) of UK properties and the credit risk associated with mortgages on those properties. They found the rate of arrears to be 18% lower among mortgages on energy efficient homes.
He said they had controlled for a number of factors including borrowers’ incomes, the property size and the wider economic conditions. He said his team had not been able to determine the causality, although hypothesised that more energy-efficient houses improve borrowers’ affordability as they need to pay less towards maintenance, have more disposable income to finance debt, and have a lower variability in the amount they have to spend.
Guin suggested that the EPC data is not yet sufficiently comprehensive to use in setting capital requirements. He said capital requirements need consistent data over time, whereas EPCs have changed and evolved.
Offering some anecdotal input from the audience, Louise Pryor, chair of the Ecology Building Society, said her institution only lends to energy-efficient properties, and has extremely low default rates. Another audience member asked how banks can be incentivised to make properties become more energy efficient, which would reduce emissions and ultimately reduce banks’ risk exposure. Guin suggested home improvement rates could be set at lower rates to incentivise investment into the stock of green houses.
Zsolt Jaczko, head of retail IRB modelling at Nationwide Building Society, also presented research on a link between the energy efficiency of houses and mortgage default rates. He and his colleagues similarly found that the owners of high and medium-energy-efficient properties seem to be less likely to default than those with low-energy-efficient properties, controlling for factors such as borrower income.
Paul Hiebert, head of the systemic risk financial institutions division at the European Central Bank, gave an insight into what the bank knows about how climate risks are materialising. He said that more is known about firms’ exposure to physical risks because that is where the data is. He said physical risks are a present reality, and two-thirds of climate risks are not insured in Europe. On the transition side, he said around two-thirds of the corporate credit exposures held by euro area banks are still directed towards high-emitting firms.
He predicted it will be around a decade until physical risks become the more dominant form of climate risk over transition risks. He said climate risks are usually first observed as market risks, then in equities, followed by corporate bonds and then credit risks.
Pierre Monnin from the Council of Economic Policies made the case for climate considerations to be incorporated into the macroprudential framework. He said he began with the assumption that climate risks are systemic risks, a view that has been expressed by the Financial Stability Board and Bank for International Settlements. He said the question is whether the current macro framework is fit to address climate systemic risk.
He pointed out that systemic risks are not something new, and the question is whether existing approaches can be repurposed in the context of climate. He said the answer in short is yes, with some adaptations. He explained that climate shares several features with other risks: they are widespread in the financial system, materialise through credit risk and market risk, can trigger sharp price corrections and can be amplified by the markets. However, they are also distinct in that they are complex, not yet observed, there is a lack of data, and they are immutable, in that they will occur in the form of either physical or transition risks.
Central banks and supervisors must go out of their comfort zone, Monnin said. There is a need to act with a lack of data, to move from backward-looking to forward-looking data, and from complete data covering all institutions to partial and incomplete data.
He argued there is a need to take early action, and central banks should be less averse to type two errors. Regulators could start by focusing on the largest institutions or the institutions that are most at risk. He suggested they could use a sandboxing approach whereby they implement some limited measures, improving and extending them as they gain more experience.
Monnin said there are two tools that central banks have in their toolbox that can address climate risk; the systemic risk buffer, which is distinct from countercyclical buffer, and concentration limits. But he also said addressing climate risk requires a holistic approach using all three pillars of the prudential framework. He said better disclosure is necessary, institutions must implement climate risk management throughout their operations including the governance level – a situation which is currently far from being the case – and an effective macroprudential framework must prevent the buildup of climate risk over time.
Monnin argued that although a carbon pricing framework is the first step to bring about the green transition and falls outside of central banks’ responsibility, macroprudential tools such as the systemic risk buffer can be used in parallel with fiscal policies in order to leverage them. He said central banks can help deliver a complementary approach to deliver the transition that is needed.
A member of the audience asked how concentration limits can be used without unintended consequences or distortions: for example avoiding a disproportionate effect on smaller banks with more concentrated business models or geographies. Monnin replied that they reflect where the risk is located, so it’s not unfair that particularly exposed institutions will be more affected. He stressed it is important that macroprudential tools are applied based on forward-looking indicators, and do not penalise firms that are making an effort on the transition. He suggested concentration limits could also be applied first to large institutions, since that is where most of the risk is.
David Aikman, director of the KCL Qatar Centre for Global Banking and Finance, suggested there is a risk of banks and insurers moving out of carbon-intensive sectors in a disorderly way. He said reputational fears may cause institutions to move en masse, a dynamic which could be reinforced by the actions of supervisors. Macroprudential policymakers may need to “step on the brakes”, he argued, as well as addressing the emergence of bubbles in green finance.
Jeremy McDaniels and Katie Rismanchi from the Institute of International Finance argued that changes to the capital regime appear to be unwarranted when considering existing data, and as such would be premature. They suggested the focus on supervisory engagement is currently the most effective and efficient way to further develop the prudential regime for climate risks.
Rismanchi suggested it is possible to account for climate risk drivers within the existing framework, given that external credit ratings are applied within calculation of capital. She said there is not yet a conclusive body of evidence for widespread risk differentials between green and dirty assets. She argued incorporating a specific climate element into the pillar 1 requirements would be a departure from the internationally-agreed approach. Likewise, she suggested that the evidence from central banks’ scenario analysis does not yet point to solvency concerns in the near term, which weakens the case for use of the systemic risk buffer.
She warned that incorporating climate considerations could lead to “subjective choices”, with potential adverse consequences including reduced credit provision.
In a poll taken at the end of the session, 93 of 182 attendees said both micro and macroprudential elements are most appropriate to reflect the risk from climate change into the capital framework, while 34 said it was too early to tell. In addition, 31 said microprudential firm-specific elements, 19 selected system-wide macroprudential elements and five opted for neither microprudential nor macroprudential tools.
This page was last updated October 20, 2022
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