A Silver Bullet Against Green Swans

Minimum capital requirements for financial firms who finance fossil-fuel companies and projects are a “silver bullet” to reduce systemic climate-related risks to the financial sector, finds this ground-breaking report from research and advocacy group Finance Watch. It argues that a European Commission review of the regulatory framework on capital requirements offers an opportunity to quickly address these risks, calling for a ‘one-for-one’ rule or full-equity financing to be immediately applied.

The report begins with an overview of the climate finance doom loop in which financial institutions are impacted by climatic events, while also contributing to the cause of these events by financing high emission activities. It identifies the specific features that characterise climate-related financial risks, including devastating ‘green swan’ risks that are certain to occur but almost impossible to predict with any accuracy.

The study shows that the irrelevance of historical data and the long time horizon of risk materialisation make traditional risk modelling ineffective, with the only certainty being that climate risks grow with continued inaction.

Faced with these difficulties, the study then examines three ‘pillars’ of prudential tools to incorporate climate-related financial risks: climate-related financial disclosures; risk management and supervisory reviews; and minimum capital requirements.

After a comprehensive discussion of the advantages and disadvantages of each of these methods, the report finds that while each prudential pillar is useful in addressing climate risk, regulatory capital requirements are by far the most impactful. However this tool has so far remained completely unused.

Given the vast scale of a potential climate catastrophe and the substantial uncertainty surrounding climate risk, the rationale for such an approach lies in the precautionary principle. By minimising microprudential risks such as stranded assets while at the same time mitigating climate-related macroprudential risks, one-for-one capital requirements also fulfill the requirements of double materiality, thus breaking the climate finance doom loop.

An ongoing European Commission review of the EU capital requirements directive and capital requirements regulation, part of the Basel 3 finalisation, offers a unique, immediate and high-impact opportunity to correct this omission, the report concludes. A concurrent review of the Solvency 2II directive, aimed at making the insurance sector more resilient, offers a similar opportunity.

“Minimum capital requirements can be differentiated based on risk for any new and existing fossil fuel plays,” said report author Julia Symon. “In particular, for new fossil fuels, a ‘one-for-one’ rule or full-equity financing should be applied.”