In the UK, these global trends are supported by research published by the Prudential Regulatory Authority (PRA). In its report published in September 2018 on the financial risks facing the UK banking sector as a result of climate change11, the PRA identified two risk factors which manifest as increasing credit, market and operational risk
- Physical risks – arising from climate and weather-related events, potentially resulting in large financial losses and impairing the creditworthiness of borrowers; and
- Transition risks – arising from the process of adjustment towards a low-carbon economy (for example policy and technological changes).
The PRA’s findings revealed that UK banks, building societies and regulated asset managers have begun transitioning from viewing climate change primarily through the lens of corporate social responsibility policy to viewing it as a financialrisk to their business. 60 per cent of the UK banking sector surveyed had begun considering the most immediate physical risks to their business models and were beginning to factor transition risks into decision making, albeit from a relatively narrow and a short-term perspective of 3-5 years. Only 10 per cent of those surveyed were taking a strategic view, engaging at board level to manage the long-term financial risks and an orderly transition to a low-carbon economy. Based on these findings, the PRA decided to consult on supervisory expectations on how a financial institution’s governance, strategy and risk management frameworks need to incorporate climate-related risks.
The UK is committed to helping drive the transition to a lower-carbon economy and to the delivery of sustainable development goals. As one of the prominent players in this area, the UK government has introduced measures to better integrate sustainable investing concerns into the decision making frameworks of businesses. Measures already adopted include amendments made in 2013 by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 (SI 2013/1970), which require certain companies to disclose ESG matters, including their greenhouse gas emissions, in their directors’ report or, if of strategic importance, in their strategic report.
In June 2018, the House of Commons published its green finance report12 aimed at embedding sustainability in financial decision making. In doing so, businesses and regulators must factor long-term environmental risks into financial decision making. The report recommends the government should do this by
- Clarifying in law that pension schemes and company directors have a duty to protect long-term value and should be considering environmental risks in light of this, as opposed to short-term returns (see paras 30 - 36 of the report).
- Requiring that TCFD reporting should become mandatory on a "comply or explain" basis by 2022 for all large asset owners. To help with this transition, the government should work with the Committee on Climate Change to produce policy/scenarios that can be utilised by companies and asset owners. It should be made clear to all financial entities that companies are already required to report on climate change where it is a material risk to business under the Companies Act 2006 (see paras 51 – 59 / 73 – 79 of the report).
- If there is no improvement in the monitoring and management of climate-related risks, the government should pass sustainability reporting legislation similar to that in France under Article 173 of the Energy Transition for Green Growth Act (see paras 102 – 104 of the report). Article 173 requires organisations with a balance sheet of more than €500 million to disclose in their annual reports how they integrate ESG and climate change concerns into their investment policies and risk management. This obligation is implemented on a “comply or explain” basis, providing flexibility to investors in choosing how best to fulfill the criteria under the Act.
Rather than legislative intervention, the recommendations encourage the cooperation of the government, regulators and the private sector, as does the report produced by the Green Finance Taskforce (GFT), launched in 2017 to help accelerate the growth of green finance in the UK13. The report was published in March 2018 and recommends
- Boosting investment into innovative clean technologies
- Driving demand and supply for green lending products
- Setting up Clean Growth Regeneration Zones
- Improving climate risk management with advanced data
- Building a green and resilient infrastructure pipeline
- Issuing a sovereign bond.
In this context, UK regulators are beginning to consult on measures to embed climate risk into the regulatory framework.
Building on the PRA’s September 2018 report (mentioned above), the PRA is now developing supervisory expectations for banks and insurers, t with the purpose of encouraging firms to reflect on their current approach to governance and risk management structures in responding to the financial risks arising from climate change. In October 2018, the PRA published a consultation paper on a draft supervisory statement (SS) on banks’ and insurers’ approaches to managing the financial risks from climate change14. The SS is informed by the PRA’s report noted above and is intended to complement existing policy material. The desired outcome is to encourage firms to strategically manage the financial risks from climate change, by taking account of current and future risks, and actions required to mitigate those risks. The Statement sets out the PRA’s proposed expectations, with views sought by sought by 15 January 2019. Under the SS, firms will be expected to
- That firms embed consideration of financial risks from climate change in their governance arrangements (including, clear roles and responsibilities at board level and, where appropriate, evidence of how firms monitor and manage such risks)
- Incorporate such risks into their existing risk management practices (such as inclusion of any material exposures in the Internal Capital Adequacy Assessment Process or the Own Risk and Solvency Assessment) and to provide information on exposure to board and relevant management committees
- Use scenario analysis (assessing both short and long term outcomes) to inform strategy setting and risk assessment
- Develop an approach to disclosure of such financial risks that takes into account the interaction of risk categories as well as their distinctive elements. The PRA expects firms to consider disclosure in the context of existing disclosure requirements on material risks under Pillar 3 disclosures of the Capital Requirements Regulation and Solvency II, and on principal risks and uncertainties in the strategic report required under the Companies Act 2006. The PRA also expects firms to engage in wider initiatives such as the TCFD.
Firms are now assessing the proposals carefully and considering the changes required to governance and management practices should the Statement be adopted.
The Financial Conduct Authority (FCA) is also looking into these issues. In October 2018, the FCA published a Discussion Paper on the impact of climate change and green finance on financial services15, setting out how the impacts of climate change are relevant to the protection of consumers and market integrity. The FCA also considers the opportunities for financial services, as a result of the transition to a low carbon economy, including the opportunity to grow as a centre for green finance, but notes that there are currently no minimum standards and guiding principles for measuring performance and impact of green finance products. Feedback is sought by January 31, 2019.
The discussion paper also identifies four areas requiring greater regulatory focus:
- In relation to pension invesments, given the time periods products are held for, the FCA proposes addressing the recommendations of the Law Commission’s report on Pension Funds and Social Investment by consulting on rules changes and guidance on assessing and reporting on financial and non-financial factors including climate change.
- Enabling innovation in specialist green products and ensuring these markets work well and deliver good outcomes for all consumers. The FCA sees two potential ways to further enable innovative models in green finance and ethical investing. Firstly, building on its 2018 proposal to create a global regulatory sandbox utilising its collaboration with the Global Financial Innovation Network (GFIN) to provide more efficient ways for innovative firms to interact with financial services regulators and navigate between countries when seeking to scale up ideas. GFIN will also create a new framework for co-operation between regulators on innovation related topics. Secondly, GFIN could also be used to explore, share ideas and experiences (including barriers to market) and/or collaborate on green finance. In this context, the FCA announced the Innovate Green FinTech Challenge, calling for the development of innovative financial products and services to assist in the transition to a low carbon economy. As mentioned above, innovation in green products is already taking place within voluntary frameworks such as the Green Loan Principles and the Climate Bonds Initiative. For information on green bonds, please see our article here.
- The FCA is also considering whether a framework is needed for issuers of securities to give investors appropriate information about climate-change related factors when securities are issued and on an ongoing basis. It explores one method of encouraging consistency by requiring companies with premium listed equity shares to provide a statement to investors explaining whether or not they have followed the TCFD recommendations in preparing their disclosures, and if not, why not (applying the ‘comply or explain’ principle mentioned above). The FCA is also seeking feedback on whether issuers require greater clarity as to what is expected of them, but notes that it is already committed to consulting on guidance to issuers on how the current regulatory regime might be interpreted to apply to climate-related risks, reflecting the FCA’s view that existing disclosure obligations would capture the reporting implications of climate change on a business where it is material to the company’s prospects.
- More broadly, the FCA is also seeking views on whether a requirement for firms to report on climate risks would be valuable, how this might be structured and who might be required to compile such a climate risk report.
To help banks overcome the challenges posed by the risks of climate change, the PRA and FCA are working to establish a Climate Financial Risk Forum, aimed at improving data and furthering the development of climate-related scenarios.