‘Capital frameworks shouldn’t be used to address climate change causes’, PRA argues

Written by Adam Cadle

28/10/2021

Capital frameworks should not be used to address the causes of climate change, the PRA has said.

In its Climate Change Adaptation Report 2021, the regulator said a number of external commentators suggest that regulators should introduce ‘carbon penalising factors’ and/or ‘green supporting factors’ for exposures to assets or counterparties that are respectively more or less carbon intensive.

“The key rational suggested for such interventions is to facilitate a quicker transition to a zet-zero economy by channelling funding to more environmentally-friendly activities and by increasing the cost of business for carbon-intensive activities. Central banks and regulators do indeed have a role to play in supporting governments to achieve a transition to net-zero, where this is consistent with their objectives. For instance, in the UK, the Bank has set out plans to green its approach to investments via the Corporate Bond Purchase Scheme (CBPS) to incentivise companies to change their behaviours in meaningful and lasting ways that support orderly transition to net-zero by 2050.”

However the PRA said there are two key factors that suggest that the regulatory capital framework specifically, in contract to other policy tools, is not an effective or appropriate way of achieving these policy objectives.

“First, capital requirements seem unlikely to be the most effective tool in reducing carbon-intensive activities unless calibrated at more extreme levels,” it argued. “This reflects the fact that capital requirements are only one of many components driving decisions by financial firms. They face other drivers of costs and opportunities, which is why the PRA has focused its efforts on ensuring firms adopt a strategic approach to managing climate-related financial risks. Other more direct public policy interventions, for instance emissions regulations or carbon pricing, would offer better incentives for action across the wider economy.

“Other studies suggest that the calibration of climate-related supporting and penalising factors would need to be very large to have any meaningful influence. Relatedly, it is challenging to differentiate capital requirements based on specific underlying activities (e.g. underneath the corporate name) which is where incentives are ultimately most efficient. In particular, with regards to ‘penalising factors’, even if banks and insurance firms were to retreat from certain markets, other investors not subject to regulatory capital requirements are likely to fill the gaps, leaving the overall impact on emissions unchanged.”

Secondly, the regulator said there could be “important unintended consequences associated with the use of capital in this way – most crucially a deterioration of safety and soundness, as current measures of ‘greenness’ or the transition alignment of exposures are not necessarily reflective of the financial risk they pose, meaning capital calibrated on this basis could not be appropriately risk-based”.

"This would make such use inconsistent with the Bank’s and PRA’s objectives. Particularly, ‘supporting’ factors could result in environmental considerations overriding (other) prudential risks. This could result in investments in ‘green’ (but otherwise risky) investments receiving too generous a capital treatment and/or an overall decrease in capital in the system (if not corrected elsewhere in the capital stack). This could threaten the safety and soundness of individual firms and may even have financial stability implications. On the other hand, ‘penalising’ factors, where not appropriately calibrated, might deprive finance for key services to consumers or businesses needed during the transition (e.g. certain types of insurance or lending to households). In addition, some business might not be green today but could become green in the future. Perversely, penalising factors could stop the financing of initiatives focussed on greening of businesses that are currently not (yet) green, despite such activity representing an important part of the transition.”

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