IPCC Report – The UN Urges Act Now to Prevent Climate-Driven Financial Shocks

The Achievable and Available Solutions – Prudential Frameworks

The EU already has a general legal basis to take action, from the Treaty on the Functioning of the European Union, which establishes the precautionary principle as a governing principle in addressing the issues relating to the environment.

There is also a specific legal basis for action in the EU’s Capital Requirements Regulation (CRR) and the Solvency II Directive. These rulebooks are designed to safeguard  financial stability and prevent insolvencies of financial institutions. Specifically CRR provides, among other things, for higher risk weightings in situations where the risk of loss cannot be measured precisely even if its occurrence is highly likely.

Risk weighting is part of the Basel model of bank regulation, in which equity capital requirements are applied to banks’ assets after each asset value has been weighted to reflect its risk.

Further to this, the Financial Stability Board also possesses a mandate to assess and address these risks and has been working on supervisory and regulatory approaches for this. In response to a recent consultation on the topic, Finance Watch has recommended holistically and explicitly integrating climate-related risks into existing prudential regulatory frameworks.

This comes in parallel to the principles of the Basel Committee for Banking Supervision, who recently provided its first formal guidance on climate-related financial risks from the global standard-setter and a clear attempt towards consistent supervisory expectations and practices.

Unfortunately, as Finance Watch’s Head of Research and Advocacy Julia Symon has identified, a lack of concrete measures or referenced best practices limit the impact of the Principles in terms of managing climate-related financial risks.

In June, Finance Watch and other partners called for policymakers in the European Parliament to include mandatory transition plans and capital requirements for climate-related risks related to fossil fuel finance in their review of the EU banks and insurers prudential rules.

This would include mandatory transition plans and sustainability targets to achieve the EU climate commitments, backed by governance structures and supervisory review. It highlights how supervised stewardship and engagement through transition planning can help financial institutions reduce exposure to stranded assets, especially as nations head towards the COP 27 summit in Egypt in November.

In the meantime, a number of amendments supporting these proposals have been tabled in the European Parliament for the ongoing review of the bank and insurance prudential rulebooks. The goal is creating a stable, green and transparent economy, one which is more resilient to future economic shocks.

Whether policymakers can step up to this vision, we will have to see.

Ben Cuzzupe