Banks ‘being let off hook by weak climate regulation’

Exclusive: campaigners say lack of penalties for dirty assets from Bank of England gives industry little incentive to change.

The Bank of England is facing criticism over the way it is conducting its first climate stress tests, with politicians and campaigners warning that a lack of penalties for dirty assets will give banks little incentive to clean up their act.

While the regulator has been praised for committing to the exercise, the Bank of England has come under fire for so far refusing to publish data for individual firms, and stopping short of introducing immediate capital requirements, which would make it more expensive to offer loans and services to fossil fuel companies and high carbon projects.

Campaigners are concerned that one of the UK’s most lucrative industries is being given a free pass.

“Finance is one of the priorities of Cop26, but the UK’s credibility as hosts risks being undermined by the fact it has let its banks pour more than £200bn into fossil fuels since the Paris agreement was signed,” the Green MP Caroline Lucas told the Guardian. “It needs to rectify these failures if it is to have any credibility during climate finance negotiations.”

The Bank of England is not the only regulator moving cautiously. So far, the European Central Bank and the Banque de France – which are among the few central banks to have conducted climate stress tests for their respective financial sectors to date – have only published aggregate data covering their finance industries, and have not introduced any restrictions, or deterrents, for banks serving polluting firms.

That is despite warnings from both regulators that banks will be severely affected unless they ramp up their response to the climate crisis.

Any deviation from the Paris agreement would result in higher loan losses for banks, according to the ratings agency Moody’s, rising anywhere from 3.5% in the “least disorderly” scenario, to 20% under the most extreme climate outcomes. It has raised concerns that the banking sector itself will suffer financially without swift action, which could had a ripple effect throughout the global economy.

Globally, reporting standards are low. A report by the Task Force on Climate-related Financial Disclosures (TFCD) published last year found that while bank reporting has improved since 2017, the sector continues to have the lowest percentage of disclosure for climate-related targets across all global industries, with 19% of firms meeting TFCD standards. By comparison, figures for the energy and transport sectors are 44% and 35% respectively.

Part of the challenge is that regulators are intent on gathering as much data as possible before introducing deterrents such as capital requirements, which determine the kind of financial cushion that banks must hold to protect them from risky loans and products on their balance sheets.

With such a complex exercise that looks at potential climate scenarios over the next 30 years, campaigners say the Bank of England may be setting an impossible task.

Its first climate tests – which it has not yet committed to repeat after this year – are far more complex than the regulator’s annual financial stress tests, which were introduced after the 2008 banking crash and measure banks’ resilience against economic shocks like a surge in unemployment, or a sudden collapse in house prices.

Instead, the climate tests will put banks through three scenarios with a 30-year time horizon, covering physical and transition risks, including one in which governments fail to take further steps to curb greenhouse gas emissions, resulting in average temperature increases of 3.3C, and a 3.9-metre rise in sea levels. The exercise will also look at how those scenarios could affect potential loan losses, as customers default on their loans due to slowing growth and economic uncertainty.

“If you’re looking for the perfect data set, you’re going to be disappointed because it’s never going to happen – there is always uncertainty” said James Vaccaro, who is an executive director of the Climate Safe Lending Network, which represents banks, academics and investors hoping to decarbonise the banking sector. “You’re always trying to extrapolate the past, but right now in terms of climate change, the past is not a good predictor at all of the likely future,” he said.

If that was not challenging enough, the Bank of England is also letting lenders determine how they measure their exposure to those climate risks individually, a move that it believes will foster innovation and unearth best practices that can be shared across the industry. However, that means it will take even longer for UK banks to produce comparable data that will help the public, governments and investors determine where they should apply the most pressure, or pull their business.

“At the moment the financial system is enabling and financing the forces that are driving climate change,” Lord Oates, the Liberal Democrats’ spokesperson for energy and climate change in the Lords, said. “And so the regulators have a duty to act now [and] in the absence of perfect information.”

International regulators have proved they are willing to consider capital requirements when new risks emerge. In June, the Basel Committee on Banking Supervision, which consists of regulators from the world’s leading financial centres, highlighted the potential risk around cryptocurrencies such as bitcoin, saying banks should be forced to put aside enough capital to cover 100% of potential losses.

Campaigners are calling for similar rules for climate risks. Last week, activists and academics including the historian Adam Tooze, signed an open letter to the Cop26 president, Alok Sharma, calling for the introduction of one-for one capital requirements, meaning that for every pound invested in fossil fuel projects, financial institutions such as banks and insurers would need to hold the equivalent to absorb future losses.

But not all central bankers are convinced that capital requirements on dirty assets will fully protect against financial shocks, since renewable energy and other innovative green assets could carry investment risks. There are also concerns that introducing capital requirements could cause market turmoil, since forcing a swathe of banks to raise money simultaneously could spook investors and make it more expensive for lenders to secure funds.

However, Vaccaro warned that near-term pain might be necessary to create a sustainable future for both the climate and financial system.

“We are potentially and unwittingly, perhaps even unconsciously, sacrificing long-term stability for short-term stability. In other words: don’t rock the apple cart now. But by not rocking it we basically totally hobble it from the perspective of actually getting it fit for the massive shocks that we’re expecting.”

The Bank of England said in a statement that “climate scenario exercises are new and complex across a number of dimensions”. A spokesperson said that it launched the exercise without having a perfect framework in place, since it may have taken years to do so otherwise.

“A key intention of the exercise was to build capabilities, and in some regards learn through doing. Consequently, we do not feel individual firm level disclosure at this juncture is appropriate.”

2 November 2021

The Guardian