Prudential Transition Plans

According to this report from the Grantham Research Institute at the London School of Economics, prudential transition plans could be designed to allow for more granular assessments, including intra-sectoral analysis, and to improve data collection through minimum disclosure standards and increased regularity of scenario analysis.

Transition plans are multi-year accounts that show how business models will be designed to fulfil environmental objectives. However, the authors say corporate transition plans, which focus on alignment with environmental goals, are not fit for supervisory authorities’ price and financial stability objectives.

Prudential transition plans specifically focus on financial institutions’ risk management strategies and exposures. They can be used in conjunction with other policies to identify the buildup of macrofinancial risks in the system. The authors say that the design of prudential transition plans should be built on two key design features: granular assessment and differentiated scope. Transition plans could offer a technical solution to address some of the challenges of integrating transition risks into the prudential framework.

The authors, Morgan Després and Hugh Miller, explore how to design transition plans to integrate climate risks into several areas of supervision and macroprudential policy. Specifically, they consider the large exposures framework, stress testing, risk management and disclosure.

The authors say there is a “high likelihood” that the net-zero transition will lead to a buildup of prudential risk by 2050, but there are challenges in assessing these risks within the current prudential system. These challenges include poor availability and consistency of data, modelling constraints, and the long time horizon over which risks may materialise.

Additionally, climate risks have unique characteristics that make them challenging to measure using conventional risk approaches. For example, the need to incorporate different factors such as non-linearities, forward-looking data, feedback loops, uncertainty, and fat-tailed distribution.

Frank Elderson has put forward transition plans as a possible tool for overcoming the “tragedy of the horizon”, referring to the phenomenon of overlooking transition risks that materialise in the medium-to-longer term. By setting intermediate targets, the authors say, risks can be brought into the supervisory timeframe.

First, granular assessment is needed to reflect the drivers of risk and capture intra-firm and intra-sectoral differentials. Second, they should be implemented in a differentiated manner proportional to the size, exposure and systematic exposure of financial institutions.

This paper suggests a four-component design to integrate prudential transition plans into the prudential framework:

• detailed assessment of large exposures: assess exposure across sectors, using the climate policy relevant sectors system, which categories economic activities based on climate risk
• regular scenario analysis: stress test financial portfolios against climate scenarios to determine risk exposure
• risk management: assess firms’ risk management practices and climate-related data collection practices
• transparency and disclosure: develop minimum disclosure requirements, set expectations for reducing data gaps and provide an overview of risk metrics through a dashboard.