Last year, The Financial Inclusion Centre published a major report called Time for Action – Greening the Financial System. We are following up that report with a project called The Devil is in the policy detail – will financial regulation align financial market behaviours with climate goals?
This project evaluates specific measures proposed by the main financial regulators to align the behaviours of financial markets, institutions, and consumers with climate goals. We are very grateful to Friends Provident Foundation for also supporting this follow up project.
As part of the project, we are producing a series of podcasts on the key regulatory issues. The first podcast set the scene and provided a high level view of the approach followed by the government and main financial regulators. The second podcast looked in detail at the role of the Financial Conduct Authority (FCA), touching on The Pensions Regulator (TPR). This third podcast looks in more detail at the role of Parliament, government, the Bank of England, and the Prudential Regulation Authority (PRA) – see below.
The role of Parliament and government
Greening the economy and financial system is one of the great economic and public policy challenges of our time. Parliament and government are important in this as they determine the legislative and regulatory framework within which regulators operate and decide the objectives given to regulators. As part of the Future Regulatory Framework Review, the government is proposing to require regulators to ‘have regard to’ the principle that economic growth should be consistent with the UK’s net-zero 2050 target.
This is disappointing particularly given the latest report from the UN’s Intergovernmental Panel on Climate Change (IPCC) published recently. It concluded that climate change risks are greater than previously thought and we have a brief and rapidly closing window of opportunity to adapt. This is not the time for half-hearted measures. We support other civil society organisations in their view that regulators should have a statutory objective that positively requires them to take action to help achieve the UK’s emissions reduction targets and Paris Agreement commitments of limiting global warming to 1.5 degrees.
The role of the Bank of England and the PRA
The Bank describes its objective as playing a leading role in ensuring the macroeconomy and financial system are resilient to the risks from climate change and being ‘supportive’ of the transition to a net zero economy.
The Bank has been undertaking a number of major exercises to help it understand the implications of climate risks. For example, the Climate Biennial Exploratory Scenario (CBES) attempts to: quantify the financial exposure of financial institutions, and the financial system more broadly, to climate-related risks; assess how climate risks might affect financial institutions’ business models and gauge their likely responses; and understand the implications for the provision of financial services. The results of the CBES will be published in May 2022.
The results will influence the way the Bank and PRA manage climate related risks in the financial system, and the choice of specific policy interventions to mitigate the risks to financial institutions.
The Prudential Regulation Authority (PRA) is responsible for the prudential regulation of important financial institutions that make up the financial system. The PRA mitigates the risk of critical financial institutions like banks going bust and, in the case of insurers, also failing to honour commitments to their policyholders. So, just as the Bank’s tries to ensure the financial system is resilient to climate shocks, the PRA seeks to make financial institutions resilient to climate shocks.
Is finance industry lobbying for regulatory reform a Trojan Horse?
But, there is another aspect to the role of the PRA. Government also wants the PRA to think about how policy tools can be used to channel more private capital into real economy activities that support climate goals. And the finance lobby has been very vocal in its claims that current regulation hinders its ability to invest more in the green transition.
The insurance lobby is arguing that post Brexit provides an ideal opportunity for the UK to reform a very important piece of EU legislation called Solvency II, claiming this would free up investment to support the green transition.
We need to be very careful about reforming Solvency II. To be fair, the current regime could be streamlined and improved. But, there are concerns that the proposed reforms would reduce consumer protection as insurers will be more exposed to future financial shocks – the balance sheets of some major UK insurers are not actually in that good a shape. So, there is actually a strong case for tougher, not weaker, prudential regulation now that Brexit has happened. Moreover, the current regulation doesn’t prevent insurers funding the green transition. But, the reforms insurers want could create a windfall for shareholders at the expense of consumers.
And it is not just insurers who are arguing for regulatory reform. Some in the pensions and investment industry argue for the charge cap on workplace pensions (which has proven to be a very effective consumer protection measure for pension savers) to be increased. Like the insurers, they claim this would enable greater investment in green infrastructure.
There is a broader concern about these ‘reforms’. Private finance (eg. insurers, pension funds, private equity) is a much more costly way of funding the green transition than, say, the state issuing green gilts. Using more costly funding mechanisms has real world effects – households pay higher bills/ service charges to generate the higher returns demanded by private finance. Moreover, not only is the finance lobby arguing for deregulation, some also want the state to underwrite the early stage investment risk of green projects. This is known as privatising the rewards, but socialising the risks – or ‘heads they win, tails we lose’.
To fund the green transition, we don’t need to run the risk of reducing important consumer protection measures or subsidise private finance institutions by underwriting their investment risks. There are more cost effective ways of meeting climate objectives. And we can ensure private finance institutions play their part in meeting objectives by using tough regulation to deter them from funding climate damaging activities.
Finance lobby arguments about the need for regulatory reform are probably best regarded as disingenuous, a Trojan Horse for deregulation, and a way to generate higher investment fees and windfalls for shareholders.
What about the banks?
We face the same issues with regards to the banks. How do we ensure they are resilient against climate risks, and support climate goals by not financing climate damaging activities?
There are concerns that bank regulation does not properly factor in the risks arising from climate change. The PRA has already said that it is considering whether it needs to increase the banks’ capital buffers to mitigate those risks. We won’t know the answer to this until the end of 2022.
On the second point, the Bank and the PRA have shied away from taking more responsibility for directing money flows away from climate damaging activities and to climate positive activities. Of course, it could be argued that requiring banks to hold more capital against climate risks would cause the banks to reorientate their lending away from climate damaging activities. But, this falls short of a positive statutory objective to promote financial market behaviours that support climate goals.
There will be enhanced disclosure around exposure to climate risks in the real economy and the financial system. But, as we explain in other podcasts, the proposals on disclosure are too weak.
Overall, so far the approach followed by the government and regulators, and the overall ambition for financial regulation, does not match the scale of the climate crisis.
What is happening at EU level?
Throughout the series we cover what is happening at EU level. Solvency II is also being reviewed at EU level by the European Commission and EIOPA (the EU supervisor for insurance and pensions). Similarly, the European Central Bank (ECB) and the EBA (the EU banking supervisor) are considering the approach to macroprudential (financial stability) regulation and prudential regulation at EU level.
In both cases, the issues are similar to those being discussed in the UK – how to ensure financial institutions are resilient to climate risk and how to finance climate positive activities.
It will be interesting to see how the EU authorities treat green or ‘brown’ assets. Industry lobbies are arguing for financial institutions to be given an incentive to hold green assets on their balance sheets. But, influential EU campaigners are concerned about this and would prefer that institutions are penalised for holding brown assets to act as a deterrent.
Even though we are out of the EU, what happens there still matters to UK financial services, UK consumers, and the environment. We must avoid a regulatory race to the bottom. It is to be hoped that the UK and EU stay aligned on the basis of higher standards, not lower standards. But, the power of industry lobbies within the EU and in the UK means this will be a hard fight.
NB this project relates specifically to financial regulation and the role of financial regulators. The podcasts do not cover the disruption caused to the global energy markets by the war in Ukraine. The war is likely to affect the attitudes of policymakers towards energy security and green transition. Therefore, it is likely to have an impact on finanical regulation. But, as it stands, it is unclear what the impact will be. If we can, we will return to this later on in the series if we get any sense of the direction of travel.
We hope the podcast is informative and interesting. If you have any questions or would like further information on the project, please contact Mick McAteer on firstname.lastname@example.org or email@example.com