posts | research

Breaking the climate-finance doom loop

Finance Watch published a report to show how banking prudential regulation can tackle the link between climate change and financial instability. The report calls for immediate regulatory action to end the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability. It sets out a legal basis for applying higher risk weights to banks’ exposures to existing and new fossil fuel reserves using prudential tools available in the Capital Requirements Regulation.

Finance Watch – Report
8 June 2020
Source: Finance Watch

Thierry Philipponnat, Finance Watch

Breaking the climate-finance doom loop


Tackling financial instability induced by climate change

Urgent action is needed to tackle the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability. Action by regulators and supervisors so far has not been able to break this dynamic, partly because of the difficulty of modelling the risks that climate change poses to financial stability. The report argues that risk modelling is not a prerequisite for tackling the climate-finance doom loop and that regulators already have the economic understanding of the situation, the legal basis and the regulatory tools needed to intervene immediately.

The global carbon budget will be exhausted within 10-15 years. All new fossil fuel production and a significant part of production out of existing reserves are incompatible with Paris goals to limit global warming to 1.5°C. Banks are an important source of funding for this production, witness the $2.7 trillion provided to the oil and gas industry in the four years after the Paris Agreement.

The climate-related disclosure framework emerging from EU sustainable finance regulation captures the two-way nature of the climate-finance doom loop, where finance both enables devastating climate change and will itself be devastated by climate change. But transparency measures cannot reduce on their own the macro-prudential risks that fossil fuel financing causes by enabling climate change, if anything because private agents are not responsible for the public interest.

Financial regulators and supervisors have come far in recognising the threat climate change represents for financial stability. But their actions so far, useful as they are, have been focused mainly on transparency measures and stress tests. In the best of cases, more effective prudential interventions will take years to enter into force, by when the planet’s carbon budget will be nearly exhausted.

Climate stress tests are effectively scenario-based analyses looking at how financial institutions will fare in different climate change scenarios, but they do not derive conclusions regarding the solvency of institutions. Incidentally, they seek to assess transition risk and, for some of them, physical risk but not the risk of disruption as businesses, finance and insurance providers will respond to adverse new conditions. These second-round effects can be large, unpredictable and non-linear, as the Covid-19 crisis has shown, and are almost impossible to model.

The lack of prudential action so far is grounded in a paradox: policy-makers recognise the near-impossibility of modelling climate-related risks but say that they need such modelling to be done before intervening. Unfortunately, given the short time available, late action is equivalent to doing nothing.

Climate change will have a significant impact on financial stability. Policy-makers should act now using tools already available rather than waiting to assess unquantifiable risks before acting. As a number of central bankers have noted, the situation calls for less modelling and more decisive and immediate action and coordination.

In this context, the EU must take preventive action as it is bound to do under the Treaty on the Functioning of the European Union, which establishes the precautionary principle as one of its governing principles.

The most suitable tool to do so is prudential measures targeted at banks with assets at risk of being stranded and that contribute to climate-related macro-prudential risk. The EU’s Capital Requirements Regulation (CRR) is designed to prevent financial instability and provides, among other things, for higher risk weightings in situations where the risk of loss cannot be measured precisely even if its occurrence is certain.

Applying higher risk weights to existing exposures to fossil fuel assets, which are at risk of stranding, would be consistent with the approach taken in Article 128 of CRR2 of applying 150% risk weights to exposures associated with risks that are particularly high or difficult to assess.

New fossil fuel exposures, on the other hand, create a macro-prudential risk by accelerating climate change and a larger micro-prudential risk of becoming stranded. Article 501 of CRR2 could be adapted through a risk weight chosen qualitatively, rather than attempting to measure the unquantifiable macro-prudential risks resulting from climate change. Applying a risk weight of 1250% to new fossil fuel exposures under the standardised approach with a similar floor for internal models would make these activities entirely equity-funded, an appropriate treatment for assets with the micro- and macro-prudential characteristics described above.

Given the time needed to amend legislation, the European Commission should immediately activate Article 459 of CRR to apply these risk weights until they have been inscribed in Articles 128 and 501 of CRR2, as part of the 2020 review of the Banking Package agreed in December 2018.

Given the global nature of the problem, the actions suggested to EU policy-makers in this report also need to be presented for use in other jurisdictions via the Basel Committee for Banking Supervision (BCBS) and the Financial Stability Board (FSB).

Our recommendations to target the doom loop between climate change and financial stability are far less radical and much cheaper than the actions taken in response to the Covid-19 crisis, but they target a far bigger threat for which policy-makers are already empowered and equipped to act.

Finance Watch’s recommendations

  1. Calibrate the risk weight for bank exposures to existing fossil fuel reserves at 150% in order to make it coherent with Article 128 of the CRR;
  2. Calibrate the risk weight for bank exposures to new fossil fuel reserves at 1250% in order to make the financing of new fossil fuel exposures by banks entirely equity-financed to reflect both micro-prudential and macro-prudential risks;
  3. Ensure that the modified risk weights are reflected in banks’ internal models for the purpose of calculating capital requirements;
  4. Activate Article 459 of the CRR to take immediate action and implement the modified risk weights until banks’ prudential requirements for fossil fuel exposures have been amended in CRR;
  5. Amend the risk weights for banks’ existing fossil fuel exposures in Article 128 of CRR and for banks’ new fossil fuel exposures in Article 501 of CRR;
  6. Promote the adoption of similar prudential requirements globally by engaging the Basel Committee on Banking Supervision and the Financial Stability Board.