Closing the gap: how can Asia Pacific financial regulators respond to climate risks?

Countries in the Asia Pacific region are highly vulnerable to the impacts of the climate crisis. In 2022 alone, China was plagued by drought and Pakistan suffered devastating floods, the effects of which are still being felt by millions of people. So it is imperative that central banks and regulators shift their policies to align with the Paris Agreement.

From the analysis presented in the first part of this article, it is clear that although there is some progress among Asia Pacific nations in dealing with the macroeconomic challenges of climate change, there is much more needed to match the scale and urgency of the crisis. In this second part, we outline what can and should be done to close the gap.

Sector-specific approaches

The fragmented approach to sector-by-sector policies for carbon-intensive assets can be resolved with the following recommendations for regulators:

Establish climate safeguards for clients
As a first step, regulators should require financial institutions to develop and implement sector policies outlining minimum climate safeguards for their clients, particularly in sectors with high climate risks and impacts.

Sector policies should be supported by banks embedding sustainability considerations in their existing code of conduct, as well as in investment, lending and risk guidelines. This would ensure that banks integrate climate considerations in their decision-making and risk management processes and policies.

Analyse business models
or loans or borrowers associated with a higher ESG risk, a more intensive analysis of the actual business model of the borrower is required, including a review of current and projected greenhouse gas emissions (including various climate metrics recommended by the Taskforce on Climate-related Financial Disclosures), the market environment, supervisory ESG requirements for the companies under consideration, and the likely impacts of ESG regulation on the borrower’s financial position. In the EU, for example, financial institutions are expected to use heat maps that highlight climate-related and environmental risks of individual economic (sub-)sectors in a chart or on a scaling system.

Control measures for Hong Kong
In Hong Kong, financial institutions should consider control measures for sectors that do not align with their climate strategy or risk appetite, such as imposing limitations, setting lending thresholds and adopting a tilting policy.

Apply international standards
With this framework in place, financial institutions are expected to engage with and support their clients adopting best practices based on internationally recognised sustainability standards and certification schemes. For a more effective transition, financial institutions should adopt and implement an active client engagement approach in relation to climate considerations for lending and investment activities.

This should be complemented by robust transition financial products or advisory services that support sustainability improvements in the sector based on independent science-based taxonomy. Low-carbon transition facilities offered by central banks would further encourage financial institutions to provide financing on a matching basis to support small and medium enterprises in high-carbon sectors to fund capital expenditure or working capital in the transition to low-carbon and sustainable operations.

Disclosure

Disclosure requirements still fall short and fail to capture the full scope of emissions associated with financial institutions, resulting in under-reporting of climate risk. Regulators can improve disclosures by addressing the following areas.

Disclose and analyse scope 3 emissions
According to a recent study by S&P Global, only half of the financial institutions reporting financed scope 3 emissions analyse these emissions by sector or industry, while just over 40% asses by asset class and over 10% by geography.

The scope 3 emissions of financial institutions are 700 times greater than their direct emissions, so they are increasingly expected by regulators to measure and disclose financed and facilitated emissions across the value chain, including a breakdown of data by asset class, country or region, and sector or industry. Regulatory initiatives such as the EU disclosure rules and the US Securities and Exchange Commission’s proposed climate disclosure standards are a case in point.

Disclose portfolio compositions
Beyond financed and facilitated emissions, for better understanding of exposure and its associated risk, financial institutions should disclose the composition of their lending portfolios in the sector or their exposure to carbon-intensive assets.

This would then pave the way for financial institutions to report publicly on the material and negative climate impacts associated with their business relationships at the portfolio level, as well as their time-bound transition plans in line with science-based decarbonisation strategies and objectives.

Target setting

To close the gap with climate goals set out in the Paris Agreement, targets should be based on science and supported by credible plans with specific milestones.

Develop science-based targets
In the last year, the number of validated climate science-based targets introduced by financial institutions globally has quadrupled, with banks taking the lead. Banks are also deploying sector targets that could be further scaled up with additional sector coverage and tools development. While it is still early days for financial institutions’ science-based targets, regulators could draw lessons from this market development and support Asia Pacific banks in setting, tracking and achieving their emission reduction targets.

Regulators could also benefit from the Science Based Targets initiatives (SBTi), in particular in developing the SBTi financial institutions net-zero standards which aims to create a single integrated standard for near and long-term targets. The SBTi will be developing principles for target-setting method selection and co-developing positions in areas such as fossil fuel investment policies.

Follow international guidelines
Reference can also be drawn from UN Environment Programme Finance Initiative’s guidelines for climate target setting, which outline key principles to underpin setting credible and ambitious targets in line with the Paris Agreement. Target-setting should be supported by disclosure of planned actions and milestones, including investment and lending guidelines, transition plans and climate-related sectoral policies, such as for fossil fuel sectors.

Banks are encouraged to integrate sector-specific scenarios in analysis for their targets, and should have a specific target allocated for renewable energy financing (by number or portfolio share) and explain any exclusions for carbon-intensive sectors.

Monitoring

Performance assessments can be improved by adopting international standards, and regulators must ensure smaller financial institutions and businesses are not excluded.

Require periodic reviews
There is mounting pressure for financial institutions to perform periodic reviews or state how frequently they review clients’ profiles on climate risk. Financial institutions are also expected to disclose the process for addressing non-compliance with their policies or with pre-agreed climate action plans.

One way to enhance the monitoring robustness would be to go beyond applicable laws and regulations, and incorporate internationally recognised science-based scenarios and findings, such as the International Energy Agency’s 2050 scenario which outlines an immediate stop to fossil fuel exploration and expansion.

Minimise unintended consequences
Regulators should monitor and assess the impact of their climate policy and regulatory measures on banks’ ability to finance the transition to a low-carbon economy while minimising unintended consequences such as financial exclusion of small and medium-sized enterprises.

For instance, a policy introduced in Brazil in 2017 requires systemically important banks to incorporate environmental risks in their capital adequacy assessments. A World Bank study found that the policy encouraged large banks to reallocate lending away from environmentally exposed sectors. However, the credit contraction did not significantly impact the real economy or emissions, as credit supply from smaller banks continued to increase. There was also a moderate labour reallocation from small businesses to larger ones in exposed sectors.

Regulators should therefore be cognisant of uneven policy implementation (eg requiring only large banks to perform internal capital adequacy assessment processes) to safeguard the entire financial system from climate risk.

Conclusion

Given the systemic nature of climate risks, it is imperative that banks in the Asia Pacific region make progress collectively. Regulators have an important role to play in ensuring that minimum standards are met.

From the results above, we can draw two conclusions. First, when regulation lags behind banking performance there is a need to move beyond setting minimum regulatory standards towards outlining good practice guides for banks. Although the role of regulators has tended to be in the purview of setting minimum standards and pushing lagging banks along, it is important to level the playing field while minimising unintended consequences.

Secondly, when regulation is ahead of market practice, supervisors should send a clear signal and set deadlines for banks to meet their expectations. In doing so, more capacity building could be needed to align with the expectations of the regulators and supervisors, and to further close the gap between the current practices and the goals of the Paris Agreement.