How will Covid-19 affect the financial regulatory response to climate change?

In some areas, regulatory action on climate change has been delayed

Central banks around the world have taken steps to preserve funding to the real economy. Stimulus measures have received the most media attention and authorities have also taken forbearance steps to temporarily ease the regulatory burden on banks. Regarding climate change:

1. The consultation period for the FCA’s proposals on climate-related disclosure rules has been extended from May to October 2020.
2. The BoE’s “Biennial Exploratory Scenario” on the financial risks from climate change is likely to be postponed. The Bank had planned to publish the final BES scenarios this year, and the results of the exercise in 2021.
3. The Banque de France’s climate stress test scenarios, due for publication in March, have yet to be released.
4. The joint PRA-FCA work with the Climate Financial Risk Forum (CFRF) to develop industry led guidance on how to integrate climate related risks into business decision making has been postponed indefinitely.
5. At the international level, the 26th UN Climate Change Conference (COP26) planned in Glasgow this November has been postponed to 2021.

Despite the delays, climate change remains a long-term priority for regulators

In February ESMA published its “Strategy on Sustainable Finance”. Goals include achieving supervisory convergence among National Competent Authorities (NCAs) regarding climate disclosure, and continuing to assess the risks posed by climate change to the financial system.

This was followed by two EU consultation papers, the timing and objectives of which indicate a sustained commitment to the climate crisis.

1. In early April the European Commission published a consultation on its Renewed Sustainable Finance Strategy. The proposed strategy aims to provide the policy tools to ensure that financial systems support the transition of businesses towards sustainability in the context of post Covid-19 recovery. Measures proposed encourage greater focus on long-term development and sustainability-related challenges and opportunities instead of purely short-term financial performance.  Measures also cover the reduction of climate, environmental and social risks in financial institutions and the financial system as a whole.
2. Subsequently the European Supervisory Authorities (ESAs) published a consultation on ESG disclosures. Notably, the proposed measures would require financial market participants to publish the following information on their websites: the adverse impacts of investment decisions on a set list of environmental and social factors (included in the consultation), how this impact has been measured and any mitigating actions taken. Similar requirements would be put in place for financial products; firms would need to disclose the sustainability objectives of each product and the planned proportion of total investments that are ‘sustainable.’

At an international level, the Network for Greening the Financial System (NGFS) remains committed to publishing guidance documents in the first half of this year on transition scenarios and guidelines on scenario-based climate risk analysis, current environmental risk assessments methodologies used by the financial sector and a guide on integrating climate and environmental related risk into supervision.

The future of sustainable finance regulation; parallels between Covid-19 and climate change

The above shows that climate change has not been discarded from the regulatory agenda. In fact, regulatory policy measures taken to tackle Covid-19 may end up complementing and ultimately reinforcing those to tackle climate change.

In many ways, the short-term impacts of Covid-19 provide an insight into the long-term effects of climate change – the two pose major threats to financial stability, making the current crisis a real-life stress test for a future climate crisis.

1. While the exact causes of the ongoing Covid-19 crisis have yet to be established, research shows that health emergencies are more likely to occur as climate patterns change and biodiversity is disturbed. This shows the critical need for mitigating climate and environmental risks, but also strengthening the resilience of our societies to future shocks.
2. A “carbon-intensive recovery” from the current crisis could increase the risk of a disorderly transition to a carbon-neutral economy and this has notably led to calls for governments to attach sustainability criteria to stimulus measures (e.g. requesting commitments from the airline industry to reduce carbon emissions). Both are idiosyncratic shocks to carbon-intensive sectors such as the aviation, automotive and fossil fuel industries, leading to increased credit risk to the financial services industry.
3. Both are international issues requiring global cooperation, with a key role to play for the financial services industry to prevent future crises and facilitate response efforts when shocks occur. Current collaboration between governments and financial institutions to respond to Covid-19 may serve as a valuable blueprint to climate response efforts going forward.

However, there is one major difference between Covid-19 and the climate crisis – the financial impact of the former is mostly driven by an increase in credit and liquidity risks that can be modelled depending on the duration of the lockdown. Climate risk is more challenging to quantify – because the physical and transition risks are unprecedented, historical data may not be a reliable indicator of the future.

The complex challenge around climate data and modelling makes a robust regulatory response and strong engagement from the financial sector all the more necessary.

Lessons for financial institutions

In many ways, the current crisis provides an opportunity for banks to take a longer-term, strategic approach to climate and other sustainability risks. We suggest that your firm should:

1. Continue to execute the climate action plan that was required by the PRA by October last year.
2. Reflect on your business model and strategy - and importantly on how your business can demonstrate to stakeholders (customers, investors, regulators and the wider society) that you have used the lessons learned from Covid-19 to adapt to changing consumer behaviours, policies and technologies, and boost resilience to climate and broader sustainability risks.
3. Better understand and measure your vulnerabilities to climate transition shock as a result of the sharp decline in activity across various sectors and the implications for your business exposures. This real-life data can be used to improve the robustness of your stress testing models for a disorderly transition scenario. The NGFS paper expected by end H1 2020 on scenario analysis should provide valuable insight for designing or improving internal modelling capabilities.
4. As conversations happen with clients to support their recovery, take the opportunity to discuss their post-Covid strategy and how aligned it is with the climate agenda. This will provide you with important information on your own portfolio exposures to physical and transition risks, a key input for counterparty-level scenario analysis.

Finally, the current crisis has not diminished the significant opportunities in sustainable finance. The demand for green and other sustainable assets continues to grow rapidly, and there is evidence that ESG assets have outperformed their non-ESG equivalents during the turbulences of Q1 2020. This is a compelling argument to keep your executives and boards focused on increasing sustainable financing amid the Covid-19 crisis, and to resist the temptation of increasing levels of financed carbon emissions.

They say you should never waste a crisis. With sufficient cooperation from the finance, business and international community, the future consequences of climate change can still be mitigated, but time is of the essence.

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Sources:

https://www.bankofengland.co.uk/news/2020/march/boe-announces-supervisory-and-prudential-policy-measures-to-address-the-challenges-of-covid-19 
https://www.fca.org.uk/firms/information-firms-coronavirus-covid-19-response#delayed 

https://www.esma.europa.eu/press-news/esma-news/esma-sets-out-its-strategy-sustainable-finance 
https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/2020-sustainable-finance-strategy-consultation-document_en.pdf 
https://www.ngfs.net/sites/default/files/medias/documents/ngfs_annual_report_2019.pdf 

https://ec.europa.eu/clima/policies/strategies/2050_en
https://www.ft.com/content/46bb05a9-23b2-4958-888a-c3e614d75199 
https://www.scientificamerican.com/article/democrats-want-to-include-climate-action-in-coronavirus-aid/