Climate change is now more than an ethical and reputational issue for financial services firms – both the PRA and the FCA view it as a potential material financial risk, and this year we have seen regulatory developments really gain momentum. What are the financial risks of climate change and what do the regulators currently expect of financial services firms?
What are the financial risks of climate change?
They fall into two main categories: physical risks and transition risks. The physical risks arise from extreme weather events and longer-term shifts in the climate too. They could lead to, for example, physical damage to the value of financial assets or collateral held by firms, such as household and commercial property, and ultimately increased credit risks.
Transition risks arise from the process of adjustment towards a low-carbon economy. Contributing factors here are changes in policy and regulation, disruptive technologies which change the value of existing assets or business models (such as electric vehicles or renewable energy), or shifting societal preferences. Firms which fail to mitigate, adapt or disclose the financial risks from climate change could be exposed to climate-related litigation.
What do the regulators expect?
At this stage, the PRA has published a concise set of supervisory expectations, and it expects firms to have an initial plan in place to address them. In brief, the PRA wants to ensure that firms are taking a strategic approach to the financial risks from climate change by:
- Embedding the consideration of these risks in their governance arrangements, including by dedicating adequate resources and expertise to these risks and by allocating responsibility to the relevant Senior Management functions, even at this early stage;
- Incorporating them into existing financial risk management practice, including by updating their existing risk management policies, monitoring and reporting, and by having a credible plan in place for managing exposures;
- Using scenario analysis to inform their strategy and risk assessment (including shorter term analysis within a firm’s business planning horizon and longer analysis, in the order of decades, on a range of different climate pathways); and
- Developing an approach to disclosure of these risks, over and above their current obligations to disclose risks and uncertainties. In particular, the PRA has indicated that firms should consider whether enhanced disclosure of how they manage climate change risks is appropriate, and prepare for the increasing possibility that disclosure of climate change risks will be mandated in more jurisdictions (the UK Government expects all listed companies and large asset owners to report on climate risks by 2022).
The FCA has indicated (most recently in its Feedback Statement published on 16 October 2019) that it intends to focus on three outcomes in relation to climate change and green finance: the information that issuers provide to the market, firms’ integration of material climate change risks and opportunities into their business, and consumer access to green finance products and services that meet their needs and expectations. The highlights in these three areas so far are:
- The FCA expects issuers to deal with climate change as a material risk within the current disclosure regime (such as the Prospectus Rules and Disclosure and Transparency Rules), although it intends to publish guidance on how the current regime applies to climate change and some new proposed rules in early 2020;
- The FCA has published proposed rule changes requiring firms’ Independent Governance Committees to oversee and report on firms’ environmental, social and governance (ESG) and stewardship policies by the end of 2019. Effective stewardship (making informed decisions about where to invest and proactive oversight once assets have been invested) is a particular area of interest for the FCA in this context, and on 24 October 2019 it published a Feedback Statement in response to its joint Discussion Paper with the Financial Reporting Council; and
- In terms of consumers’ access to green products and services, the FCA has said that it intends to challenge firms where it sees the potential for “greenwashing” and take action if consumers are being misled, or publish guidance if the need arises. Its initial view is that the “sustainable” label is being applied to a wide range of products where it may not always be justified. The FCA has described this area as an “active area of focus”.
How are the regulators’ expectations likely to develop?
The pace of regulation is likely to continue to accelerate. The PRA described its Supervisory Statement as a “catalyst for change among the financial sector”, and although the PRA and FCA both recognise that firms’ responses to climate change risks will mature over time, they are also looking for firms to demonstrate serious commitment quickly. This is no easy ask when there are few specific rules dealing with climate change risks, the guidance published so far is high level, and the underlying analysis required to assess long-term risk is complex and could be calibrated in many different ways. Until the regulatory architecture develops, the best approach is for firms to demonstrate strong governance and thoughtful, rational decisions in this area.