Prudential Net Zero Transition Plans

The Potential of a New Regulatory Instrument

June 10, 2024Published by Journal of Banking Regulation

New research highlights the powerful potential of prudential transition plans as a forward-looking regulatory tool to assess systemic risks stemming from financial institutions’ misalignment with climate goals. The article suggests that the quality of transition planning could influence prudential measures such as capital surcharges and systemic risk buffers, once sufficiently robust regulatory and data disclosure regimes are in place.

However, navigating challenges around data, uncertainty and capacity, as well as possible unintended consequences, will require careful coordination with non-financial sectors and across national borders, according to authors Simon Dikau, Nick Robins, Agnieszka Smoleńska, Jens van’t Klooster and Ulrich Volz.

Transition plans show how banks and other organisations intend to ensure business models and strategies are consistent with environmental objectives and mitigate climate risks.

Prudential transition plans differ from typical transition plans, as they would be prepared and assessed with the distinct purpose of managing systemic risks resulting from misalignment with climate policy goals, rather than for more general disclosure purposes.

These plans can foster a more proactive and precautionary approach to the prudential challenges posed by pervasive misalignment with net-zero goals, say the authors, and help overcome conceptual challenges associated with climate risk.

Those challenges include:

  1. limited data availability: prudential plans can help supervisors assess risks when data is limited by using misalignment with transition pathways as a proxy for material risks which cannot yet be quantified;
  2. shorter time horizons: transition plans help bring distant risks into the present supervisory timeframe;
  3. backward-looking methodologies: transition plans provide a forward-looking tool to assess how a bank’s climate risk exposures will evolve and be managed over time along specific trajectories.

Incorporating mandatory prudential transition plans into the supervisory framework can provide valuable insights for macroprudential policymakers. At an aggregate level, it would enable supervisors to gauge the fragility of the system as a whole to climate risks under various transition scenarios.

These findings can then be used to inform systemic risk buffers and large exposure limits to increase the financial system’s resilience, either system-wide for bank groups or targeted at specific high-risk sectors or locations.

Misaligned plans could also be used by prudential authorities to identify individual banks requiring prioritised supervisory attention. Meanwhile, the micro-level data included on banks’ counterparties could aid supervisors in verifying corporate climate disclosures.

The authors outline three steps for incorporating transition plans into the prudential framework:

  1. set standardised expectations for granular and science-based transition plan elements, including regular scenario analysis, disclosures, interim targets, climate risk integration, data analytics, metrics, counterparty engagement, future exposure estimates and senior management capacity building strategies;
  2. conduct supervisory assessments that assess the credibility and alignment of plans with policy objectives and likely transition pathways to identify excessive risk-taking;
  3. impose (mainly Pillar 2) supervisory consequences for inadequate transition plans and management of misalignment risk, such as capital surcharges or additional training requirements for senior staff.

The authors highlight the potential unintended consequences of incorporating prudential transition plans into the supervisory framework, such as adverse impacts on SMEs and transition finance, as well as interference with the macroprudential policies of other countries. They recommend proportionate, bottom-up approaches and collaboration with cross-border macroprudential authorities to address these challenges.

Additionally, they caution that increased bank scrutiny could disperse risk without improving macro-stability, for instance a narrow focus on early alignment could induce instability through rapid asset sell-offs. To tackle this, they say prudential planning should promote meaningful advice to clients on climate risks and opportunities.

This page was last updated June 10, 2024

Share this article