REPORTS & BRIEFINGS | 27/06/2023
Managing Climate Risk: The Role of Financial Regulators in the Net Zero Transition
This Aldersgate Group report calls on the government to provide a strong legal basis for financial regulators to support the transition to a net zero and nature positive economy. It finds that financial regulators are limited by a narrow mandate on climate, capacity and resource constraints, and a lack of comprehensive net zero-aligned policy across the economy.
The report recommends government set out a strategic and sequenced approach to financial regulators to ensure they support the implementation of the net zero transition at pace. This includes empowering them with a stronger and clearer mandate on net zero and nature, and with this mandate, the use of green prudential tools to accelerate decarbonisation and address systemic climate risk.
Implementing the net zero strategy at pace
- It is the role of government to set national net zero plans and drive the whole-of-economy transition using relevant fiscal, regulatory and economic policy levers. Financial regulators must play a complementary role to facilitate the transition with their prudential and market regulatory tools.
- To avoid a scenario where regulators are driving net zero policy or where government policy is insufficient for regulators to intervene, government must first set out a well-designed public policy foundation.
- This foundation must create incentives for investment into net zero infrastructure and nature restoration by closing the gaps in the Net Zero Strategy (2021).
Empower regulators with a stronger and clearer mandate on net zero and nature
- The Financial Services and Markets Bill, currently in Parliament, proposes giving the FCA and the PRA a new regulatory principle to have regard to the government’s commitment to reach net zero emissions by 2050.
- Regulatory principles, however, do not provide a sufficiently strong legal basis for regulators to act.
- Once the implementation of the Net Zero Strategy is well underway and strong market signals are in place, the next government should amend the Financial Services and Markets Act 2023 to explicitly include the transition to net zero and nature positive economy as a secondary objective. This will also improve regulator accountability as regulators are required to report their progress against statutory objectives.
- A Joint Commission on Climate Finance Regulation, led by the CCC and Bank of England, should advise the government on when the net zero strategy has been sufficiently developed.
With an enabling mandate, regulators should look to use green prudential tools
- The primary responsibility of financial regulators is to ensure the stability of the financial system. With an enabling mandate, regulators should look to use green prudential instruments to mitigate the systemic risk that climate change and nature loss poses to the financial system. Examples of instruments include:
- Climate-adjusted capital requirements, which requires banks investing in assets which are incompatible with a 1.5C pathway and risk becoming stranded to hold more loss-absorbing liquid capital.
- Large exposure limits, which limit a bank’s overleveraged position in carbon-intensive assets that are at high risk of stranding.
Meanwhile, financial regulators should use existing tools to support the financial sector to engage with systemic climate risk
- As the world gets closer to 2030 climate targets, there is a clear need for near-term action.
- Financial regulators should continue to support companies to manage their environmental risks and achieve genuine emissions cuts across their business operations using their existing tools.
- Financial regulators should oversee the creation and implementation of transition plans prepared by financial institutions and corporates to ensure their credibility. From 2023, UK asset managers, asset owners, and large listed companies will be required to disclose mandatory transition plans on a comply or explain basis.
Support financial regulators overcome capability constraints
- To carry out these new roles and responsibilities, it is crucial that financial regulators are sufficiently staffed and resourced.
- Relevant staff, for example, should be given formal training to ensure they have the right skills (such as accurately assessing climate-related risks and opportunities) to adapt to a changing mandate. This could be delivered through the vehicle of the re-launched Sustainable Finance Education
- Investment in resources and training should commence before the mandate is formally changed, as reskilling takes time and the transition is already underway.
- Separately, the government should also ensure the Treasury Committee has sufficient resources to adequately scrutinise financial regulators on behalf of the UK Parliament.