Prudential Supervision of Climate-Related Risks: What’s the State of Play?

As the materiality of physical and transition risks from climate change continues to increase by the day, regulatory authorities in many jurisdictions have progressively been taking such risks into greater account in their supervision of banks. In many countries, evolving regulatory landscape and supervisory expectations require banks to take a strategic, forward-looking and comprehensive approach to considering climate-related risks.

While there exist no global prudential standards on the supervision of climate risks, the Basel Committee on Banking Supervision (BCBS) concluded a consultation on 16 February 2022 regarding a principles-based guidelines for the effective management and supervision of climate-related financial risks. The Committee is currently reviewing the comments received in response to the consultation. However, several jurisdictions has already integrated climate risks into their prudential supervision frameworks before the finalisation of the BCBS principles, which is expected by the end of 2022.

The UK Prudential Regulation Authority (PRA) is the first financial regulator to publish a set of supervisory expectations on the management of climate-related financial in 2019. Climate risks appear to be one of the supervisory priorities for the PRA. On January 2022, the regulator once again expressed its expectation in a Dear CEO letter that banks integrate climate risks into their risk management and decision-making processes.

The PRA explicitly expects banks to assess their exposure to climate-related financial risks in the way they assess other drivers of financial risks. This means that the PRA may impose an additional capital charge or scalar for banks that have significant climate-related financial risk management and governance weaknesses within its Pillar 2 capital framework.

Likewise, the European Banking Authority (EBA) expects banks in the EU to actively identify and manage their climate-related risks. The EBA is also expected to fully integrate Environmental, Social and Governance (ESG) risks into the EU prudential framework, particularly with respect to Pillar 2 capital framework. This means that climate risks may have an impact on banks’ regulatory capital requirements.

Another priority for supervisory authorities in several countries has been to design stress tests for climate risks. In the recent years various methodologies have been proposed to measure related risks over the short, medium and long terms, as well as under various hypothetical scenarios. The PRA is once again the first regulator to propose a biennial climate scenario exercise to assess the resiliency of the UK banking system to different climate scenarios. 

In the EU the European Central Bank (ECB) runs supervisory climate risk stress tests to identify challenges banks face when managing related risks. While there is no direct capital impact on banks from exercise, results could indirectly impact banks’ Pillar 2 capital requirements through the Supervisory Risk and Evaluation Process.

There has also been recent regulatory and legislative initiatives requiring banks to become transparent about their climate risks and their efforts to align their portfolios with the Paris Agreement. Regulators such as the PRA, the ECB and the Securities and Exchange Commission (SEC) in the United States are pushing ahead with mandatory climate-related disclosure requirements.

Disclosures required in major jurisdictions are generally aligned with the reporting framework put forward by the Task Force on Climate-Related Financial Disclosures (TCFD) and comprise qualitative and quantitative information on the ESG risks, but may also include indicators such as alignment metrics and the green asset ratio.

The ECB, for instance, published its guide on climate-related and environmental risks in 2020, which outlined the supervisory expectations relating to the management and disclosure of climate and environment risks. In addition, the EU Banking Package 2021 proposes to require banks to systematically identify, disclose and manage ESG risks as part of their risk management.

Banks in the EU are explicitly expected to report to which extent they support economic activities that contribute substantially to achieving the EU’s net zero target in 2050. In particular, large banks will have to disclose disclosure requirements such as green asset ratio and a banking book taxonomy alignment ratio under the EBA’s Pillar 3 technical standards published on 24 January 2022.

In the UK, on the other hand, the Financial Conduct Authority (FCA) published a policy statement with respect to climate-related disclosures in June 2021 as part of its ESG strategy, introducing a disclosure regime for listed companies. The SEC in the United States followed suit, releasing a TCFD-aligned proposal on 21 March 2022 to require publicly listed companies to disclose their risks related to climate change and their greenhouse gas emissions, as well as related governance processes, metrics, targets, and goals.

An important issue with respect to climate reporting remains greenwashing. In February 2022, the European Securities and Markets Authority (ESMA) published its Sustainable Finance Roadmap to address greenwashing. In the same month, the European Banking Federation and the United Nations Environment Programme Finance Initiative, published a joint report on the EU Taxonomy, a classification instrument designed to address the greenwashing risk.

More recently, considerations of ecological and biological degradation have also been added to the regulatory agenda. With the development of the Taskforce on Nature-related Financial Disclosures (TNFD), the financial sector is increasingly expected to take steps to embed biodiversity considerations into their strategies, operations and risk management processes. TNFD is expected to launch a framework on disclosures of risks from biodiversity loss and ecosystem degradation in 2023. 

Many banks have already made significant efforts to begin incorporating ESG into existing frameworks. However, several challenges remain. For instance, the PRA’s 2021 climate change adaptation report and the ECB’s 2020 stocktake on the transparency of banks’ disclosures followed by its March 2022 review on the banks’ management of climate and environmental risks show that many banks face significant challenges in terms of the availability of comparable, granular data as well as reliable methodologies.

In conclusion, banks have been increasingly called upon to meet various supervisory expectations with respect to public disclosures, capital planning and governance. With remaining regulatory authorities around the world mandating active climate risk management and disclosures in line with the forthcoming BCBS principles, the pressure on banks to act on climate-related risks will only intensify with time.

Mete Feridun is Chair of the Centre for Financial Regulation and Risk Management, and Professor of Finance at the Department of Banking and Finance, Eastern Mediterranean University in Cyprus