ESG and prudential regulation - how should banks be responding?

Where might we be going?

Developments to date have concentrated predominantly on Pillar 2 and Pillar 3 - but regulators in the UK and other jurisdictions have also sent strong signals that they are actively reviewing the entire capital regime, including Pillar 1. Recent communications from the PRA, EBA, ECB, and Basel Committee have been used to suggest that the current framework may only partially capture climate-related risks.⁸ The problems highlighted with current frameworks are multiple:

• Firms face material data gaps. For example, they do not generally hold primary, verified data on the carbon emissions associated with each of their investments. Physical risk variables also fluctuate significantly under different climate scenarios.

• Pillar 1 framework was designed around cyclical economic fluctuations. Climate change is non-cyclical in nature and has not previously occurred at the pace currently observed. This makes backward-looking data - which is central to current capital calculations - unsuitable.

• Current methodologies focus on traditional business cycles while climate risks are expected to materialise over a longer time period.

• Risk weights and external credit scores are often defined without consideration to climate risk. The use of broad asset classes to set risk weights cannot capture sectoral and geographical concentrations - for example regions or industries which are highly exposed to physical or transition risk.⁹

• The extent to which the current regime captures climate-related risks is unclear. Imposing wholesale changes to integrate climate therefore risks ‘double counting’ - and potentially imposing higher capital constraints than necessary.

The nature and extent of these problems has prompted active debate over how to make the capital framework more appropriate. Two schools of thought are emerging. One favours setting out dedicated prudential treatments - ie. specific, discrete changes to capital frameworks - for climate risk. These are generally envisaged through the use of green/brown risk-weighted asset (RWA) multipliers for specific asset classes depending on sustainability criteria.¹⁰ A hypothetical ‘green supporting factor’ would decrease the risk weight attached to ‘sustainable’ assets, lowering the capital offset required. A hypothetical ‘brown penalising factor’ would increase the risk weight attached to ‘unsustainable’ assets, increasing the capital offset required.

A more nuanced option involves tailored adjustments to the current framework to better account for environmental factors. This could involve firms incorporating climate risk more fully into different components of their RWA calculations. For example, a mortgage lender might increase Loss Given Default estimates for a property portfolio with high exposure to flood risk, increasing the risk-weighting as a result. Environmental factors could also be more fully integrated into credit ratings.¹¹

Both the PRA and EBA have been cautious in their messaging to date. The EBA’s May 2022 discussion paper formed an initial conclusion that ‘preference should be given to consideration of enhancements within the existing Pillar 1 framework, rather than to the use of supporting or penalising (green/brown) factors¹², while a recent speech from the PRA indicated that ‘it is not yet clear that…the magnitude of transition costs require a fundamental recalibration of capital requirements.¹³ But both bodies remain committed to fully exploring the debate - the Bank of England will hold a conference on the topic in Q4 this year and the EBA has asked for responses to its own discussion paper by 2 August 2022.

What does this mean for banks

This is clearly a moving target, but firms can still be proactive. We see five near-term priorities:

1. Actively engaging in the debate around how prudential frameworks might change and collaborating with partners across the industry to help shape the most appropriate solution.
2. Transforming ESG systems, data and processes in readiness for future requirements (for example - working towards robust taxonomy or emissions reporting).
3. Identifying decarbonisation levers, setting targets, and synthesising these into a credible, practicable transition plan.
4. Approximating the impact potential changes to capital requirements might have on ratios as part of scenario analysis.
5. Ensuring compliance with those prudential requirements already in place as part of a clearly defined wider ESG regulatory programme.