Should capital requirements be used to address climate-related risks?

04 November 2021

The Prudential Regulation Authority (“PRA”) has recently published its Climate Change Adaption Report 2021 where it provides the regulator’s view on the:

  • progress firms have made against managing climate-related risks and the PRA’s 2022 supervisory strategy on climate-related risk.
  • relationship between climate change and the banking/insurance capital regimes including outlining the gaps and the PRA’s strategy

What progress have firms made towards management of climate-related financial risk?

The PRA’s supervisory expectations on climate-related risks was published in 2019 and firms should demonstrate how they meet these expectations by December 2021.

The feedback on firms’ progress centres on four areas of supervisory expectation:

  • Governance: most firms have a SMF with assigned responsibility for climate-related risk.
  • Risk Management: the integration of climate-related risks into risk management framework has been constrained by a lack of granular data. This limits firms’ ability to set risk appetite and limits.
  • Scenario Analysis: some firms struggle to construct relevant scenarios and have limited data to support the scenario analysis.
  • Disclosure: Some firms disclose qualitative ESG information in line with the TCFD best practice framework. Firms will be required to disclose material climate-related risks in their Pillar 3 reports from the end of 2021.

The PRA has stated that it will use a wide range of supervisory tools in 2022 to monitor compliance with climate-related risk requirements including s166 reviews and Pillar B capital scalars. 

How should capital requirements be used to address climate-related risk?

PRA has assessed how capital frameworks can be used to address climate-related risk and has identified the following:

Capital can be used for the consequences, not the causes of climate change:

  • Using capital requirements to affect financing and investment decisions directly is not effective unless calibrated at very high levels (i.e. high risk weighting of polluting assets). These levels could give rise to unintended consequences, such as the erosion of capital in the system or build-up of risks in other areas.
  • Ultimately, regulatory capital cannot substitute for government climate policy and the cause of climate-related risks (i.e. greenhouse gas emissions).
  • The PRA has identified that it will use Pillar 2A add-ons and capital buffers/scalars to address the consequences of climate-related risk exposure and management. For example, the PRA expects firms to incorporate judgements of their exposure to climate-related risk in the overall Pillar 2A risk assessment.

Climate-related financial risks are partially captured by current frameworks, but there are gaps:

  • difficulties in estimating climate-related risks due to lack of relevant granular data or modelling techniques that can fully incorporate climate factors (capability gaps).
  • challenges in capturing climate-related financial risks due to the design or use of methodologies in capital regimes themselves (regime gaps).

The PRA will undertake further analysis to explore enhancements to the regulatory capital frameworks. This work is expected to complete in December 2022 and will be done in parallel with work undertaken by the Basel Committee.

What should firms do?

Given the ongoing focus on climate-related risk and expectation that firms must implement the expectations set out in Supervisory Statement SS3/19 by December 2021, it is critical that firms undertake a gap analysis of how they meet these requirements.

In particular, firms should continue to develop and enhance its capabilities in setting risk appetite and limits for climate-related risks. This is important as the firms are required to identify their material exposures and demonstrate they are holding adequate Pillar 2 capital against them.

How BDO can help?

If you would like to discuss the above or would like to understand how BDO can help your firm with undertaking a gap analysis against the climate-related risks or identifying how climate-related risk should be managed or quantified, please contact Leigh Treacy, Richard Weighell or Oivind Andresen