From Disclosure to Regulation: Potential Impacts of Climate-related Regulation of Banks

The Covid-19 pandemic has revealed that some of our national and global institutions were not adequately prepared to address a known risk. This experience underscores the question of whether major financial institutions are adequately prepared for other known risks—those associated with global climate change.

For some time, big banks have faced growing pressure to direct their resources away from assets subject to climate-related risks and toward assets that can decarbonize the global economy. To date, this pressure has come in the form of calls for voluntary disclosure. Stakeholder groups have pushed banks, insurers, and asset owners onto myriad reporting and disclosure platforms. Though these platforms having become increasingly rigorous, much of the disclosed information is qualitative and impressionistic. The resulting information mostly defies comparative assessment.

However, a shift is now underway from the voluntary to the regulatory realm. And while the ultimate outcome is still yet to be determined and much further along in Europe than it is in the United States, financial services regulators ultimately could reach for the potent macroprudential regulatory tools (those designed to limit financial system risk exposure) now at their disposal as a result of the 2008 financial crisis.

Even a near-term stop on the track from voluntary to regulatory could have meaningful impacts. Financial services regulators are currently working to develop climate-risk “stress tests.” Formulating these tests necessarily will involve standardizing terms, metrics, and scenarios for climate risk and for green financing. Banks will be under substantial pressure to conform their operations to the results of any standardized assessments by their regulators. One question is whether these stress tests and their associated standards—even without regulatory obligations on the banks—could re-channel capital flows in significant ways. Could stress tests and enhanced disclosure for banks be a potent climate policy?

What Is Climate Risk?

Before diving into the evolving regulatory landscape, it is important to understand what climate risk is. On the exposure side of this equation, the concern is that major financials are unprepared for two categories of climate risks: physical risks and transition risks.

Physical risks arise from the increasing severity of climate-driven weather events. Such events not only damage property, infrastructure, and agricultural output, they also disrupt supply chains and could drive refugee migration. Physical risks affect asset values and public finances. They increase the likelihood that insurers and reinsurers will face substantial underwriting losses.

Transition risks arise from the shift to a net-zero carbon economy. This shift will result in an adjustment of a broad range of assets, changes in energy prices, and reduced revenues and creditworthiness for many bank counterparties. The magnitude of transition risk will be a function of the timing and stringency of the policies adopted for the transition.

In addition, there is interdependence between physical risk and transition risk. In one scenario, timely adoption of meaningful policies could minimize transition risk and stem physical risk. Conversely, a delay in the adoption of workable climate policies could result in runaway climate change, prompting the adoption of draconian policies that could abruptly restructure the global economy.

Financial institutions are also, in some contexts, being assessed for the positive role they are playing to mitigate climate risk through climate-friendly investments. Some investments, like those in renewable energy, would count, but as we discuss later other types of investment are less straight forward.

The Growing Demand for Regulation

Today, financials are inundated with calls for disclosure from multiple civil society organizations, which are promoting multiple and heterogeneous voluntary disclosure platforms. Although there has been some welcome consolidation through the Task Force on Climate-related Financial Disclosures, the scatter diagram of disclosure is less than satisfying for all parties. The disclosure efforts are resource-intensive exercises for even the big financial institutions. Further, the proliferation of inconsistent platforms complicates assessment or comparative analysis.

It does not help that much of the disclosed information is qualitative and impressionistic. One criticism is that the outcomes are not only vague, they are not actionable. A recent report and initiative launched by the Rocky Mountain Institute with several major banks seeks to overcome five major barriers to turning these assessments into actionable plans to achieve climate-aligned finance. A second criticism is that the assessments do not seem credible. There is a debate on both sides here. Companies and investors say the focus on climate risk overemphasizes one set of risks relative to other risks (geopolitical or technological risk perhaps—one must wonder how pandemic risks fit into their risk frameworks). On the other hand, environmental stakeholders claim the way companies think about risk is irresponsible (i.e., a company can say they see no risk to its oil and gas reserves over a 5-10 year timeframe and, by setting that timeframe, avoid discussing potential risk just beyond that time horizon).

This does not mean that financials are not taking concrete actions in response to advocacy around disclosure. So far, responding to these requests has been about planning and communicating. At the very basic level, investors have been asking companies and insurers (and their regulators) whether and how they assess and disclose their climate risk. The next step is to ensure they have a process to periodically reassess that risk. Last, they want to know if they have a strategy for dealing with that risk.

So far most of this activity has taken place absent the role of regulators, particularly in the United States, less so in Europe. This is changing.

Senator Elizabeth Warren (D-MA) has written letters to each of the major banks demanding more disclosure, better definition of terms, and more concrete actions. Warren was also a key contributor to the report issued this August by the Senate Democrats’ Special Committee on the Climate Crisis. The report, which has 167 mentions of the term “bank,” includes extensive recommendations for financial regulators. The Commodity Futures Trading Commission (CFTC) has formed a Climate-Related Market Risk Subcommittee that is expected to issue a report later this year with recommendations on what U.S. financial regulators could do to compel banks to identify and manage climate risks and how the financial system can facilitate a transition to a resilient, low-carbon economy.

In addition, Ceres, a climate-oriented nongovernmental organization working primarily with pension funds and other large financial investors, has outlined 50 policy recommendations to be carried out by seven U.S. financial regulatory agencies. Of particular appeal for Ceres and other stakeholder advocates is that many elements of macroprudential regulation might not require enabling measures by Congress. A paper published by the Great Democracy Initiative asserts that the Dodd-Frank law, the legislation passed in the wake of the 2008 financial crisis, provides ample authority to roll out a financial services regulatory regime based on managing climate change-related systemic risk to the financial sector.

These initiatives have a kind of contingent character to them; their ultimate audience is likely a hoped-for Biden administration or future Democratic-controlled Congress. Not surprisingly, European policymakers are moving faster than their U.S. counterparts. Under EU law, securities issuers will face mandatory disclosure obligations in 2022. In addition, the European Banking Authority (EBA) has a five-year Action Plan to implement several already enacted EU regulations and directives.

EU policymakers are building a policy infrastructure around environment, social, and governance (ESG) risk and opportunity management—with a strong emphasis on climate. The EBA Action Plan charts a course through increasing standardization to ultimate prescription. The first step is to continue to refine the EU Taxonomy—a system that aims to define what types of investments can count as furthering “environmental” or “social” aims. The EBA also is working to bring more substantive content to the concepts of physical and transition climate risks. In particular, the EBA aims to develop quantitative metrics for these concepts for use in disclosures.

Once this definitional infrastructure in place, the EBA will move to standard setting. The EBA will use the Taxonomy to establish guidelines for what banks can take credit for as green lending or as a low-carbon index. And with uniform definitions of risks, the EBA will roll out climate-related stress tests for financials and insurers. Developed in response to the 2008 financial crises, stress tests are used to identify systemic risks across the financial sector and can be used at the level of individual banks. The Bank of England is already taking steps to conduct climate-related stress tests for banks and insurers within its jurisdiction in 2021 and initially will provide aggregated (rather than institution-by-institution) results.

The EBA workplan contemplates that stress tests ultimately will inform future prudential regulation, i.e., requirements for banks to control risks through capital requirements, liquidity requirements, or through limits on large exposures. Applied in the climate context, such regulation might relax capital requirements—which govern the amount of money banks must hold against the risk of losses—for lending and investments that fit into the green side of the Taxonomy and tighten those requirements for lending and investments subject to identified physical or transition risks.

What Will the Stress Tests Stress?

As the Bank of England moves toward its 2021 stress test, it is working to develop quantitative metrics for these categories of risk and is crafting scenarios that can be modeled. The Bank’s choices could have real impacts on the assessments. In the area of physical risk, there have been substantial analytical advances. It is becoming feasible to model physical risk at more and more granular levels, including for specific properties, utilities, and other assets. With these advances, the stress tests could yield highly specific assessments of the vulnerability of banks and major insurers to different scenarios for weather events and chronic changes in temperature and precipitation. The tests could demonstrate, for example, that a range of investments in coastal assets are not prudent.

Another question is whether the Bank of England will conclude that prudent management of physical risk entails not only avoiding climate-exposed assets but also an affirmative obligation to engage in green financing as we suggested earlier. In other words, should we expect major financials to do their part to avoid dangerous climate change by ensuring that a certain amount of their capital goes to underwriting climate mitigation and resilience activities? Should such an expectation be a regulatory obligation?

This is not exactly a straightforward question. For example, in developing a taxonomy for green financing, will loans and other financing for nuclear power plants count or not? Will it still be possible for a green bond to finance nuclear?

Similarly, will it be possible to offer favorable green financing terms for a liquefied natural gas plant or natural gas infrastructure in a developing country if it can be demonstrated that it is displacing electricity generation powered by coal or fuel oil? Or, conversely, will any and all natural gas-related investments be considered subject to transition risk and therefore potentially face higher margin requirements or other regulatory thumbs on the scale that lead to a higher cost of capital?

In addition, much is at stake in the choices made by bank regulators to give flesh to the concept of transition risk. A number of voluntary reporting efforts have asked banks or companies to develop scenarios for how they would avoid a two-degree Celsius increase in global temperatures. These have been wooly and imprecise exercises, as would be expected from asking an individual entity what part it should play in avoiding a global temperature increase.

The Bank of England is already homing in on a more clear-cut exercise, considering policy-based approaches that would direct banks to evaluate particular carbon prices and regulatory structures—and then mapping these policy scenarios onto the bank’s counterparties. In doing so, it is building off the efforts of the Network of Central Banks and Supervisors for Greening the Financial System, a coalition of central banks (excepting the U.S. Federal Reserve) that aims to strengthen the response to systemic climate risk in the financial sector and meet the goals of the Paris Agreement.

Yet bringing greater rigor and quantitative content to modeling physical and transition risks is not easy. The Bank of England has acknowledged that its recommended 30-year modeling horizon for these risks is much longer than typically used for stress tests. In addition, it recognizes the challenges that banks will face in translating broad global scenarios into rigorous bottom-up analysis of individual exposures to company counterparties. For these reasons, the Bank of England has emphasized that its initial effort will be “exploratory” and not necessarily result in new regulatory requirements.

What Impacts Can We Expect?

Stress tests and the drive to more comprehensive bank regulation certainly have the potential to expose climate risks in the banking sector. But does bank regulation also have the potential to meaningfully alter the flow of global capital in the direction of decarbonization? In other words, how effective is climate-related bank regulation as climate policy?

There may be some limits to this potential. For one thing, investments from the big banks do not necessarily comprise a big proportion of global capital. The Economist magazine recently calculated that publicly traded companies account for only 14 percent of total global greenhouse gas (GHG) emissions. Bank regulations do not reach all of the broad array of players in global financial markets, including money market funds, hedge funds, and pension funds. In the energy sector in particular, sovereign wealth funds are the dominant sources of capital. In this way, the situation in the financial sector parallels the oil and gas sector. Some of the world’s largest international oil and gas majors have started making significant moves to decarbonize. However, their share of production is eclipsed by the nationally owned companies, which are moving far slower.

In addition, climate-related regulation of banks is not a substitute for more direct climate policies. Making banks react to hypothetical future GHG policies is inferior to having them react to actual GHG policies that are well designed and send predictable long-term signals. Similarly, pressuring banks to redirect capital to green investments will be more effective if there are a host of other supportive policies for such assets, including research, design, and development (RD&D) funding. For these reasons, in the absence of real and well-designed climate policies, bank regulation could generate at least some amount of economic waste and long-term uncertainty in capital markets.

This is not to say that stress tests and other climate regulation of banks will not have value—even while the United States is still developing more comprehensive climate policies. It is vitally important to understand the exposure of the banking sector to climate risks. Taxonomies and other standards adopted by the central banks have a way of proliferating over time. Just as banks and financial institutions shore up their entire portfolio to avoid other types of idiosyncratic risks—like the risk of U.S. sanctions—the mere emergence of government-established methodologies may prompt banks to scrutinize their portfolios for climate risk more stringently. In addition, stress tests and similar exercises can change the culture and norms of banking, building awareness and more analytical rigor of the downside of emissions-intensive assets and the upside of green investments.

This commentary does not necessarily reflect the views of Van Ness Feldman, LLP, or its clients.

Kyle Danish is a senior associate (non-resident) with the Energy Security and Climate Change Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C and a partner in the Washington, D.C., office of Van Ness Feldman, LLP. Sarah Ladislaw is senior vice president and director and senior fellow of the CSIS Energy Security and Climate Change Program.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2020 by the Center for Strategic and International Studies. All rights reserved.

Kyle Danish
Senior Associate (Non-resident), Energy Security and Climate Change Program
Sarah Ladislaw

Sarah Ladislaw

Former Senior Associate (Non-resident), Energy Security and Climate Change Program