The UK government has recently issued a Call for Evidence to support the update of its Green Finance Strategy. The strategy has three objectives:
- Greening finance by supporting the financial services sector to align with the UK’s net zero commitment, the need to adapt to climate change and the UK’s commitment to nature’s recovery.
- Financing green by mobilising private investment at scale to support clean and resilient growth.
- Supporting financial services to capture the opportunity presented by the transition to a net zero and nature-positive economy, cementing UK leadership in green finance and ensuring that businesses can benefit.
Financial Inclusion Centre has submitted its response to the call for evidence. See here: Financial Inclusion Centre Submission Government Green Strategy Update FINAL VERSION 0622
Below, we summarise the key elements of our response. We are concerned that the legislative and regulatory framework, and specific regulations, rules, and guidance are not fit-for-purpose and will not drive the necessary change in the financial system and markets. A different approach is needed if UK financial markets are to support climate goals and if the UK is to be a leading effective, trusted, and reputable global centre of green finance.
For more detailed analysis of the structural, market, institutional, infrastructure, and regulatory issues that inhibit the alignment of financial market activities and behaviours with climate goals, please see Financial Inclusion Centre report Time for Action.[1]
Building an effective, trusted, and reputable green finance sector
The government wants the UK to be a leading global centre for green finance (GCGF). We very much support this ambition. The UK financial sector has much to offer. But, a different approach to the one currently followed by the government and financial regulators is needed if the UK is to be a leading effective, trusted, and reputable global centre of green finance.
The success of the UK as a green finance centre should not just be judged on how fast or large it grows. The quality of green finance and the business the UK attracts is just as, if not more, important as the quantity. The green finance developed in the UK must be effective in driving climate positive behaviours in the real economy.
The activities of any financial centre claiming to be green must be meaningfully aligned with climate goals and net zero commitments. But, recent research found that global stock markets are funding companies with three times more coal, oil and gas reserves than can be burned without breaking the 1.5°C Paris climate target. In the UK, The London Stock Exchange holds 47 GtCO2 of embedded emissions. This is 30 times more than those of the UK’s own fossil fuel reserves (1.5 GtCO2) and ten times more than its 15-year carbon budget from 2023-37 (4.7 GtCO2).[1]
We argue that if the UK is to be a leading global centre for green finance (GCGF) it should be built on the following principles and values:
Effectiveness, efficiency, and neutrality The green finance strategy creating the GCGF should be neutral and promote the most effective, efficient forms of climate funding, not accord preferred status to any particular form. Greening the financial system and underlying real economy will require sustained efforts over the long term. Therefore, green finance must be sustainable and aligned with the long term nature of climate goals. This will be a challenge given the short termism prevalent in UK financial markets.
Genuine financial innovation Market behaviours and the financial products and instruments produced by the UK financial sector should make a real, measurable contribution to climate objectives. Growth in new ‘green branded’ products or financial market activity should not necessarily be taken as evidence of environmental, economic and social utility.
Systemically robust and stable There is now a better understanding of the link between climate change and i. systemic risks in the financial system; and ii. risks to specific financial institutions. A successful GCGF should promote financial system and market behaviours that contribute to environmental, economic, and financial system stability (in the UK and, given the importance of the UK financial sector, globally). But, the current proposals for climate related financial regulation do not fully recognise or address those risks – see below.
Integrity and trustworthiness A reputable green finance centre should be a beacon of integrity, transparency, and good corporate governance. It should compete by operating to the highest standards, not by promoting a race to the bottom on regulation. Users (domestic and global) of a UK centre of green finance should be able to have a high degree of confidence and trust in UK financial system, markets, and financial institutions – and that confidence and trust should be justified.
Well regulated, accountable, and transparent A world class GCGF will require world class climate related financial regulation (financial stability, prudential, market, and conduct of business) and the highest standards of corporate accountability. But, the current proposals for climate related financial regulation are not fit-for-purpose. Crucial to effective regulation will be regulatory independence. We are very concerned that the direction of travel evident in the proposed reforms of the UK financial regulatory system post Brexit would compromise regulatory independence. Regulators should be free to ensure that quality of business takes precedence over quantity of business. The principles of transparency and openness should be embedded into the operations of a GCGF. This requires moving away from prevalent regulatory culture in the UK which limits transparency to protect commercial interests.
Better policymaking and regulation
Crucial to building a green finance sector are the right financial policies and a system of effective, robust financial regulation (financial stability, prudential, market, and conduct of business). But, our analysis tells us that the high level legislative and regulatory framework, and specific regulations, rules, and guidance are not fit-for-purpose and will not drive the necessary change in the financial system and markets.[2] It is not at all clear that policymakers and regulators fully recognise the financial risks associated with climate change – particularly the impact on households. The UK, with its heavily financialised economic system is particularly exposed to climate-related financial risks. [3]
To be a success, financial policy and regulation must:
- Align the behaviours and activities of the financial system,[4] markets, and institutions with climate goals; and
- Actively direct financial resources to climate positive economic activities and away from climate damaging activities. Financial policy and regulation must: i. cause financial institutions to disinvest and divest from their existing stock[5] of climate damaging assets; and ii. ensure the flow of new funding (public and private)[6] is allocated to climate positive economic activities and directed away from climate damaging activities.
We make a number of recommendations on better financial regulation.
High level recommendations, statutory objectives
- The financial system and overall approach to financial market regulation needs coordination and direction. The Bank of England should be given new statutory objectives to promote financial market behaviours that contribute to economic and environmental sustainability; and, specifically, to ensure the activities of the UK’s financial sector contribute to the goal of 1.5 degrees of warming.
- Government and Bank of England should establish a Financial Sustainability Committee (FSC) along the lines of the Monetary Policy Committee (MPC). The FSC should take responsibility for the Bank’s new statutory objectives described above and coordinate the work of all the regulators involved in managing climate related risks – the Bank of England, Prudential Regulation Authority (PRA), Financial Conduct Authority (FCA), The Pensions Regulator (TPR), and the Financial Reporting Council (FRC). The FSC should publish an annual report on its activities plus a wider triennial review on progress against its objectives.
- The PRA, FCA, TPR, and FRC should be given new obligations to support and have regard to the impact of their policies on the Bank of England’s sustainability objectives. The FCA, PRA, TPR, and FRC should also publish an assessment in their annual reports on how their activities have contributed to the objective of the FSC.
- The FCA should be responsible for overseeing how financial institutions, listed companies and larger private companies comply with sustainable/ climate, responsible, and social impact (SRI) finance criteria, and disclose compliance. The FRC should retain responsibility for ensuring the auditing of underlying economic activities meet regulatory requirements. Reporting on SRI compliance should be made a statutory requirement rather than voluntary, with appropriate sanctions for non-compliance with reporting standards. There needs to be greater focus on supply chains in the economy.[7] The FRC and FCA should collaborate on improving the standards of audit and reporting on compliance with climate goals in financial supply chains.
- Financial institutions provide finance to firms in the real economy, so compliance with climate goals in the real economy supply chains are critical, too. The Competition and Markets Authority (CMA) has developed a Green Claims Code to ‘help businesses comply with the law’. But, the CMA says little about how breaches will be enforced against. Codes per se are a light touch form of regulation, and do not have a good track record in constraining poor practices in key economic sectors. But, using a code is all the more surprising given that the CMA working with other global authorities found that 40 percent of green claims made online could be misleading suggesting that thousands of businesses could be breaking the law.[8] The CMA should adopt a more robust approach to supervising behaviours and enforcing against breaches in the real economy. This should include the supply chains of key consumer sectors – it has been estimated that the supply chain accounts for more than 90 percent of most consumer goods companies’ environmental impact.[9]
Prudential regulation and consumer protection
- Post Brexit, the government is consulting on reforms to a critical piece of EU insurance legislation called Solvency II. The main concern relates to a technical measure within Solvency II called the Matching Adjustment (MA).[10] Insurers are claiming reform to the MA is needed to enable insurers to fund green infrastructure (and ‘levelling up’). We think this is disingenuous and suspect the real aim is to provide shareholders with a windfall. Moreover, we are very concerned that government’s proposals would lead to a reduction in consumer protection for policyholders and pension savers.[11]
- Some might argue that these reforms are worth the price if it encourages insurers to fund green infrastructure. But, it does not make sense to reduce the protection available to policyholders and pension savers just to enable a costly way of funding green infrastructure (using insurance funds for green infrastructure is costly compared to state funding). And finance lobbies are also pushing for the state to ‘de-risk’ long term green assets – in other words, the state (taxpayers) should underwrite the early stage risk while they retain the long term rewards.
- Moreover, the proposed reforms to Solvency II do not actually recognise the scale and nature of climate related financial risks. There are better ways of aligning insurance funds with climate goals, without compromising consumer protection.
- The Bank of England/ Prudential Regulation Authority should direct insurance and pension resources to climate positive activities (green assets) by deterring funding of climate damaging activities (brown assets). Financial regulators should require insurers (and banks and asset managers) to have credible and demanding transition plans in place (to green their activities) with clear targets and timeframes.
- Once transition plans have been approved, specific policy tools will be needed to implement these plans. We very much support the idea that policymakers and prudential regulators should adopt the “One for One” Rule. That is, for each £ of resource that finances new climate damaging activities, insurers should hold a £ of their own-funds held liable for potential losses.[12] An alternative would be to adjust the ‘own-funds requirement’ by reference to an independent assessment of the climate damage caused by an economic activity.[13]
- That would address the flow of new funds. We would still need to deal with the stock of existing climate damaging assets. Insurers should have to hold a proportion of own-funds against existing holdings – this proportion would be increased over an appropriate time frame to incentivise insurers to divest these assets in line with the transition plans described above.
- Similar issues arise with regards to prudential regulation of banks (although it is worth noting that banks do not benefit from the perverse matching adjustment incentive available to insurers). The One-for-One Rule outlined above should also be adopted for calculating Pillar 1 capital requirements for banks.
- Industry lobbies have been claiming that charge caps on pension schemes should be relaxed to ‘facilitate’ investment in green finance infrastructure and levelling up. Again, we believe this is disingenuous and the real aim here is allow private finance to generate higher returns and higher fees (greater value extraction). There is no case for increasing pension charges. Undermining an important consumer protection measure to facilitate a more costly form of funding does not make sense.
Conduct of business regulation, information disclosure
With regards to conduct of business regulation, the FCA is relying heavily on improving disclosure and transparency. The FCA wants to introduce a tiered approach to disclosing information. This is appropriate as different external users of relevant data and information (such as investors, pension funds, civil society) will need to have access to (or be interested in) different levels of component data.
But, the classification system proposed by the FCA is not robust and could result in confusion. In particular, the low level criteria that financial institutions would have to meet to be allowed to market and promote their funds and products as ‘Responsible’ and ‘Sustainable’ could lead to greenwashing, misselling, misrepresentation, and investors inadvertently making poor financial decisions. We urge the FCA to rethink its proposals on classifying financial activities according to green compliance and develop a consistent, reliable classification system. [14]
We are also very concerned about the lack of detail on how the FCA will supervise compliance with its rules and how claims made by financial institutions are to be independently audited to ensure that any label or rating system is not built on misleading foundations. In addition, we have concerns about the proposals for auditing real economy firms’ compliance with climate disclosures.[15] The FCA and FRC should spell out clearly how they intend to supervise compliance with climate related regulations and rules, and make it clear to the market that they intend to enforce abuse aggressively.
The absence of a robust foundational taxonomy must be urgently addressed if financial stability, prudential, conduct of business, and reporting and disclosure regulation is to be effective – see below.
Regulatory culture and approach
The dominant culture and attitudes within the UK regulatory system is a cause for concern. UK regulators are relying far too much on ‘encouraging’ the market to produce the necessary realignment of climate related financial behaviours and activities.
Historically, UK financial conduct regulators have tended to follow a permissive approach to regulation, intervening only when there is evidence of harm that cannot be ignored. This is not the appropriate approach for managing climate risks. We cannot afford to wait. Financial market behaviours will only align with climate goals if financial institutions are made to fully appreciate and recognise the cost of failing to do so. The experience of repeated financial scandals and crises tells us that we cannot rely on the market dynamics to reveal and ‘signal’ the true cost of market failure or compel financial institutions to respond.
Tackling the climate crisis will require a precautionary approach to financial regulation, not the permissive market-orientated approach hitherto favoured by UK financial regulators. It will require direction from policymakers through the appropriate legislative framework, statutory objectives provided to regulators, and robust pre-emptive, ex ante, precautionary interventions on the part of regulators that deter climate damaging financial activities – see above.
UK financial regulators do not appear to be as willing to take action against financial firms suspected of ‘greenwashing’ as some of their overseas counterparts.[16] We urge the FCA to speed up plans to use its enforcement powers against financial institutions and intermediaries which are deliberately or inadvertently misrepresenting climate related information and misleading consumers.
The need for better climate related financial data and data ecosystem
Effective, trustworthy, relevant, and useful research, data, and information is needed all along the financial supply chain (for example, the foundational taxonomy, investment labels, and ratings systems).
As outlined above, we have serious reservations about the FCA’s proposals for an investment label. Moreover, we are also lacking a workable foundational green taxonomy. The effectiveness of each aspect of financial regulation (financial stability, prudential, conduct of business, and financial reporting and disclosure regulation) will be undermined without a robust, trusted foundational taxonomy. The lessons from the financial crisis in 2008, tells us that trustworthy market and regulatory data and information is critical to preventing crises. The same will apply to managing the climate crisis. We urge financial policymakers and regulators to increase their efforts to develop and implement a green taxonomy which should:
- make it clear which economic activities are climate supporting (green) and climate damaging (brown); and
- allow for assessment of the contribution each part of the financial supply chain makes to the green transition.
There are a number of other steps UK government and regulators can take to support a robust data ecosystem.
As well as lacking a foundational taxonomy, there are limited independent sources of data free from conflicts of interest, and trustworthy benchmarks and consistent ratings to judge how well financial activities comply with climate criteria. Data and research on risks and rewards associated with climate assets is still very limited. The amount of effort and cost required to identify potential opportunities can deter financial institutions and retail consumers. Therefore, we recommend that government should convene stakeholders to collaborate on developing a central repository of information, research, and risk analysis on climate related finance. This should be accessible to financial institutions, regulators, pension trustees and citizen-investors.
The other major data related issue is the role of external ratings agencies. Commercial ratings agencies are expected to play a critical role in influencing climate related financial decisions. The commercial credit ratings agencies played a significant role in the 2008 financial crisis. They were accused of producing misleading information and not managing conflicts of interest between them and the financial institutions they rated. We must ensure we do not repeat those mistakes when it comes to dealing with the climate crisis. Climate related data and information needs to be objective, relevant, trustworthy, and accessible. In an ideal world, green assessment and ratings would be undertaken by a non-profit, public interest organisation. This would avoid the conflicts of interest inherent in the provision of ratings by commercial organisations. But, that is not going to happen, so it is important that commercial agencies are regulated very closely. We very much support the idea of bringing ratings agencies within FCA regulation. The FCA should be more prescriptive about the methodologies used by ratings agencies as the lack of standardisation and consistency in the provision of ratings undermines the ability of end users to make informed decisions.
For further information on these issues please contact: mick.mcateer@inclusioncentre.org.uk or mickmcateer92@gmail.com
[1] Exchanges carrying 3 times more carbon reserves than can be burned under Paris – Carbon Tracker Initiative
[2] Further detail can be found in Time for Action Time for Action – Greening the Financial System | The Financial Inclusion Centre
[3] See: People in US and UK face huge financial hit if fossil fuels lose value, study shows | Fossil fuels | The Guardian
[4] When we refer to the financial system, we include institutions of the state and the Bank of England, not just private sector institutions
[5] Held in the form of loans provided to and shares and bonds held in listed/ tradeable companies or larger privately owned companies
[6] When we refer to climate related funding or financial resources we include state/ public funding not just market based private finance (eg. banks, insurers, pension funds, asset managers, private equity and so on)
[7] The supply chain accounts for more than 90% of most consumer goods companies’ environmental impact. For more detail see: Podcast: The Devil is in the policy detail – the role of disclosure and reporting, standards setting bodies, and audit and accountancy professions | The Financial Inclusion Centre
[8] Greenwashing: CMA puts businesses on notice – GOV.UK (www.gov.uk)
[9] For more detail see: Podcast: The Devil is in the policy detail – the role of disclosure and reporting, standards setting bodies, and audit and accountancy professions | The Financial Inclusion Centre
[10] A technical provision called the Matching Adjustment allows insurers to book returns on long term investments up front. This benefits shareholders but leaves policyholders exposed to the risk that these projected returns will not materialise.
[11] The use of the MA already artificially inflates the strength of the balance sheets of a number of major UK insurers. See: Regulation is masking the true condition of insurers | Financial Times (ft.com) What the government and insurers propose would allow a wider range of assets to be eligible for the MA. This would further benefit shareholders and expose policyholders to more risk.
[12] https://www.finance-watch.org/the-one-for-one-rule-a-way-for-cop26-ambitions-to-manifest-in-policy/
[13] But, this would require a robust foundational taxonomy which we do not have
[14] Financial-Inclusion-Centre-submission-to-FCA-dp21-4-final.pdf (inclusioncentre.co.uk)
[15] Podcast: The Devil is in the policy detail – the role of disclosure and reporting, standards setting bodies, and audit and accountancy professions | The Financial Inclusion Centre
[16] SEC investigating Goldman Sachs for ESG claims | Financial Times (ft.com) DWS chief resigns after police raid over greenwashing claims | Financial Times