After years of warnings on the tremendous macro-economic consequences of the unfolding climate crisis[1], financial supervisors are finally acknowledging that regulatory action on climate risks is a necessity in order to fulfil their financial stability mandate[2].
Indeed, by financing the fossil fuel industry, financial institutions create both micro prudential risks and macroprudential risks in
what Finance Watch calls a “climate finance doom loop” (see infographic
below). Fossil fuel finance is a risk for financial stability that unequivocally fits under the current mandate of supervisory authorities.
The Climate Finance Doom Loop: Fossil fuel finance enables climate change, and climate change threatens financial stability
As expected, and given their influence on the conduct of financial
markets, supervisors and regulators are opting for a cautious approach
to tackling the problem of climate risks. But the very nature of their
actions shows that they don’t take into account the “tragedy of the horizon” inherent to the impact of the climate crisis on the financial system.
If the Bank of International Settlements itself has described[3] how climate-related extreme events of increasing frequency called “Green Swans” would be a) of systemic importance, and b) impossible to quantify, they omit to reiterate that the “tragedy of the horizon” structurally prevents market participants from incorporating the real cost of sustainability risks in their operations.
Yet, so far, the entire toolkit on which they base their actions is
built on the following assumptions that are entirely contradictory to
their own diagnostic and that of the “tragedy of the horizon”:
- Quantitative approach to climate risks: The current
approach to scenario analysis, climate risk modelling and mandatory
disclosure is quantitative and backward looking, therefore unable to
account for green swans. These tools focus on “transition risk”
while barely approaching the more important and unquantifiable
“physical and disruption risks”.
- Underlying “efficient market hypothesis”: The approach so far is solely based on a “market information approach” where market participants would naturally
fully integrate newly disclosed risks and adapt their investment
behaviours accordingly, thereby “accounting for climate risks” without
need for further regulatory action. This approach is based on
transparency and governance (like the Pillar II and Pillar III
approaches of the Basel framework) and is usually thought of as a substitute
to strong reliable prudential rules (so-called Pillar I rules) that
would reflect the risk that we have to manage in a coherent manner. But
there is only so much that transparency and information can do in the
absence of a proper prudential regulation.
- Decades-long timeline for implementation:
Regardless of the toolkit, the current implementation timeline for a
market-wide, significant action is still thought of as a tentative “soft
landing” for markets. Such long-term regulatory action isn’t compatible
with the timeline of the climate crisis. On climate risks, slow action
equals no action.
Illustration of the dangers of a quantitative approach to transition risk in the face of the systemic risk of climate change
In this context, the slow – and market-based – set of measures
currently contemplated by supervisors very much looks like a dangerous
game of procrastination in the face of the biggest threat financial
stability ever faced. The outcome of their action is likely to be the exact opposite of the one they seek if extra steps are not undertaken urgently. In a context of shrinking carbon budget and of massive support of the fossil fuel industry by the financial sector[4], every lost day increases the systemic risks of the climate crisis.
It is time for regulators to stop shying away and to make use of their only reliable weapon against financial risk: the increase of capital requirements.
The existing prudential regulation framework already allows them to act[5],
and as it happens, EU prudential regulations of the banking and the
insurance industries – by far the most significant funders of the fossil
fuel industry -, are being reviewed by the Commission in 2021, allowing
for immediate action[6].
In Europe, the political will is lacking and the Commission is under
pressure from Member States not to act, on the back of short term views
that aim to protect local industrial or financial interests. But political pressure increases by the day[7].[8]
There is still time to right the ship, both at European and at
International level. Will supervisors be fit for the task and perform
their duty? The ongoing international supervisors mega-show on climate
risks (the Green Swan conference where Finance Watch is represented by Thierry Philipponnat on panel H)
will probably give us an idea of their frame of mind on this topic and
the likeliness of todays’ supervisors to enter history as saviours or
villains.
Finance Watch
© Finance Watch
Key
Hover over the blue highlighted
text to view the acronym meaning
Hover
over these icons for more information
Comments:
No Comments for this Article