Greening the Financial System

    What it means, why it's necessary, and how regulation is enabling the transformation

    When we think of the risks from climate change, we often think of the longer-term consequences on global temperatures, the effects of melting ice and rising sea levels on certain animal habitats or low-lying island nations, or, as we've been forced to confront with increasing frequency, extreme weather events such as heat waves and hurricanes, and their destructive impacts in the form of forest fires and flooding. And, as regulators and central banks are now acutely aware, these "physical risks" represent only one component of the overall risk posed by climate change to the world's economies and on the global financial system.

    There is now global consensus on the impact of human activities on the climate and also conversely of the impact of climate change on human activities. Governments and multinational bodies consider the steps needed to introduce targets to limit global warming (such as the Paris Agreement) and to reach net-zero emissions (such as the UK's 2050 Net Zero Target). Financial regulators consider the "greening of the financial system" as a necessary step to developing a more sustainable and resilient financial system, which is robust in the face of climate change and also supports better allocation of capital to sustainable activities.

    The global financial crisis of 2007-2008 highlighted the fragility of the financial system in the face of systemic shocks. Climate change is one of these shocks. Climate risk – whether physical (as described above), "transition risk" arising from the impact of policy and regulatory changes on businesses and operations, or "liability risk" arising from individuals or businesses seeking compensation for losses suffered as a result of physical or transition risks – is now recognised as a massive source of systemic risk, and therefore must be understood and managed by financial institutions and their supervisory bodies. Physical risk can impact factories, supply chains and workforces. Transition risk has the potential to disrupt entire business models, as certain high-emissions activities are severely curtailed or banned outright.

    Greening financial industry

    Central banks and regulators are increasingly concerned about the potential for this climate risk to crystallise, the impact on firms' business models, share prices and creditworthiness, and the knock-on impact to the asset managers, banks and other financial institutions that are exposed to them. As a result of the financial crisis, they now have an established toolbox at their disposal with which to manage this risk at a systemic level, via the financial institutions under their direct supervision. This includes prudential measures such as requiring financial institutions to incorporate climate risk into their ongoing risk management, liquidity and capital adequacy requirements, and running stress tests at both the individual institution and industry level through initiatives such as the Bank of England's 2021 Biennial Exploratory Scenario on Financial Risks from Climate Change. Following its publication in 2019 of Supervisory Statement 3/19 on "Enhancing banks' and insurers' approaches to managing the financial risks from climate change", there is now a clear expectation from the Bank that firms under its supervision should have "fully embedded their approaches to managing climate-related financial risks by the end of 2021".

    There is a clear need to incorporate climate risk into pricing and risk management processes. At present, however, the climate risk posed to most firms remains poorly understood. It is not incorporated into share price valuations or factored into the cost of financing by lenders and other buyers of debt. It does not form a component of counterparty risk, and therefore is not priced into longer term derivative contracts. This lack of understanding at the individual firm level makes it difficult for financial institutions to assess their exposure to climate risk via their investments. It also makes it difficult for them to understand how to better allocate capital in order to meet their own internal, or externally imposed, targets for financing of sustainable activities. For some, such as pension fund and asset managers, understanding their climate risk exposure is seen as a way of enabling them to better start managing climate risk in their portfolio now, and divesting themselves of potentially high-risk investments. For others, such as executing brokers, there is a desire to remain in line with the pack, and to price consistently with the rest of the market.

    Data, obtained via mandatory reporting requirements, plays a significant role here. For all firms across the economy, the incorporation of climate risk into their annual disclosures is the starting point for understanding climate risk at a systemic level. To be useable and useful, such disclosures must also be consistent in granularity, format and approach. Initiatives such as the Task Force on Climate-Related Financial Disclosures (TCFD) are working with global standards bodies to develop improved climate disclosure standards. In November 2020, the UK became the first country in the world to announce a roadmap towards mandatory TCFD-aligned disclosures across all sectors of the economy by 2025. Such data, when available, can then be incorporated into pricing and risk management. Elsewhere, the EU's guidance on its Non-Financial Reporting Directive encourages firms to make their climate-related disclosures in line with TCFD recommendations.

    Some regulators are also starting to look at proactive measures to improve capital allocation for sustainable activities and businesses. Banks, for example, may have internal targets on how they will transition their client portfolio towards "green" or sustainable companies and projects. In the absence of clear definitions around such activities, there is a risk of "greenwashing", whereby firms divert financing towards projects that have only superficial green credentials. The EU's Taxonomy Regulation aims to provide "a common language and a clear definition of what is "sustainable"". This will enable the development of financial products and services that direct capital towards sustainable investments in a way that is clear and transparent to investors.

    It will take a huge amount of work to transform the financial system into one that can better support sustainable objectives and remain resilient in the face of climate change. Fortunately, we have the tools to measure and to understand such systemic risks. The question has long been, instead, whether governments and regulators had the will to deploy these tools. Climate risk is now so high on the regulatory agenda that 95 central banks and supervisory regulators have now come together under the banner of the Network for Greening the Financial System (NGFS), whose purpose is to share best practices and to contribute towards the development of a more sustainable economy and financial system. And this may just be the start of a wider transformation towards more purpose-led finance. Whilst most focus to date has been on the "E" in ESG, due in no small part to its urgency, the same principles of regulation that are being applied now to the problem of climate risk could in the future be transferred to the "S", and the integration of measurable social impact into the financial system.

     This blog was written by Jannah Patchay.

    Jannah Patchay

    Jannah specialises in financial markets innovation. Across two decades' experience in the Financial Services sector, she has provided advisory, consulting and delivery services to a wide cross-section of market participants including exchanges, tier-1 investment banks, brokers, funds and start-up businesses.

    This includes a range of engagements for clients, including assisting in the launch of new trading venues, businesses, products and services, interpreting and implementing new regulations, and advising on regulatory, business and operational strategy. Her regulatory subject matter expertise lies in financial market structures and applicable regulations, such as Dodd-Frank, EMIR and MiFID / MiFIR, with a particular emphasis on cross-border and extraterritorial issues.

    She is a Director and Regulatory Advocacy Ambassador of the London Blockchain Foundation, driving the regulatory agenda and leading regulatory consultation responses and advocacy with respect to the emerging digital assets sector. As a member of the Whitechapel Think Tank's Future of Payments WG (with representatives from industry, government and academia, and supported by Innovate Finance and the City of London Corporation) she is also involved developing policy recommendations and advocacy around digital money and its potential for advancing financial inclusion and payments innovation. Jannah covers financial innovation topics as a freelance journalist.