Bank of England, the royal exchange in London

Climate risk regulation rundown: July 2022

July 29, 2022

What happened in climate-related financial regulation last month, and what’s coming up

The Financial Stability Oversight Council (FSOC), the US’ top financial regulatory body, received an update on its member agencies’ efforts to combat climate-related risks at a meeting on July 28.

The FSOC published a factsheet following the meeting outlining the “considerable progress” made advancing the panel’s recommendations on addressing climate risks, which were laid out in a report published in October last year. 

The paper also described the work of the FSOC’s Climate-related Financial Risk Committee, made up of staff from all 15 of the body’s member agencies. This committee has met since February 2022 and serves as an “active forum for interagency information sharing, coordination, and capacity building,” the factsheet says.

Michael Barr was sworn in as Vice Chair for Supervision at the Federal Reserve on July 19. As the Fed’s top banking regulator, Barr has the power to shape the central bank’s response to climate risks to the US financial system.

At a Senate confirmation hearing in May, Barr said the Fed has “important but quite limited” authority to tackle climate-related financial risks.

Barr was President Biden’s second pick for the position of Wall Street’s top cop. His first choice, Sarah Bloom Raskin, withdrew from consideration after senators expressed opposition to her views on managing climate-related financial risks.

The Office of Financial Research (OFR), an arm of the US Treasury, released a ‘Climate Analytics and Data Hub’ to help federal agencies monitor climate risks to the financial system.

Released on July 28, the Hub allows regulators to integrate climate-related information from across the federal government — including data on wildfires, crop conditions, and rainfall patterns — with their own supervisory datasets. The tool also offers statistical and visualization tools to better illustrate climate-related financial risks. 

The Hub is being piloted by the Federal Reserve Board and Federal Reserve Bank of New York ahead of a broader roll-out to all the agencies represented on the FSOC.

The Commodity Futures Trading Commission (CFTC) on July 18 announced it was extending the comment period for its Request for Information (RFI) on climate-related financial risk.

The consultation, launched on June 2, was initially scheduled to end on August 8. It will now be open until October 7.

Responses to the RFI will be used to inform potential CFTC actions to address climate risks to US derivatives markets, such as the issuance of new or amended guidance, interpretations, policy statements, or regulations.

The European Central Bank (ECB) said it would further integrate climate considerations in its monetary policy following a July 4 decision by its Governing Council.

Specifically, the central bank pledged to change how it purchases corporate bonds — prioritizing climate-friendly assets and relegating carbon-intensive instruments. Issuers will be assessed on the basis of their greenhouse gas emissions, their carbon reduction targets, and the quality of their climate-related financial disclosures. The new regime will come into effect from October this year.

Isabel Schnabel, an executive board member of the ECB, said the overhaul would impact around €30 billion of ECB bond reinvestments each year, or about 10% of the bank’s overall corporate portfolio.

The ECB also said it would restrict the amount of carbon-intensive bonds financial institutions will be able to lend to the central bank in exchange for cash from 2024.

On July 8 the ECB published the results of its first supervisory climate stress test, which covered 104 banks. This showed that European lenders could take a €70 billion hit from a sharp jump in carbon prices and a wave of natural catastrophes.

This loss figure combines credit and market losses estimated under a short-term transition risk scenario and two physical risk scenarios — one covering flood risk and another drought and heat wave risk. Forty-one banks participated in this part of the ECB’s exercise, and only around one-third of their total exposures were subjected to the stresses. 

The exercise also found that about 60% of banks still do not have a climate risk stress-testing framework. Most banks do not factor climate into their credit risk models, either. In addition, the ECB discovered that on aggregate about two-thirds of banks’ income comes from carbon-intensive clients.

The stress test consisted of three modules. In the first, each bank submitted data on their own climate stress-testing capabilities. In the second, they disclosed the amount of income they generate from carbon-intensive borrowers. In the third, they calculated their performance under macro-financial scenarios covering short-term and long-term climate shocks.

All participants in the stress test have been given individual feedback, the ECB said.

An ECB report published July 26 shows that climate shocks could ricochet through the European financial system, piling losses on to banks and real-economy companies alike.

Transition and physical risks could trigger a cascade of corporate defaults, the report says. For example, a spike in carbon prices could lead to a domino effect where the collapse of one company leads to the default of another, and another, and so on. Meanwhile, physical risks “can cluster together and exacerbate each other,” the report says. It adds that financial market behavior can amplify the impact of these physical shocks by “causing a sudden reassessment of climate risk pricing, thereby causing fire sales, where financial institutions — especially those with overlapping portfolios — quickly sell a large number of exposed assets at the same time at distressed prices.”

The report also argues that macroprudential policies are required to gird the EU financial system to these climate shocks. These include existing tools like the systemic risk buffer, concentration limits, and borrower based measures.

“Crossholdings and common exposures across the financial system will likely amplify the materialisation of climate risks, warranting the inclusion of a system-wide perspective for the policy response,” the report says.

In a working paper published July 4, ECB economists gauged how climate risk is factored into eurozone equity markets. The paper’s authors constructed two climate risk indicators — one for transition risk, the other for physical risk — using a text analysis approach. These found that climate risk premia for both risks have increased since the 2015 Paris Agreement.

Another working paper, published July 26, focuses on financial markets and green innovation. Among its findings, the paper says that the ECB’s monetary policies “have limited effectiveness” when it comes to stimulating climate-friendly products and services because the central bank faces legal and economic challenges.

“For one, green monetary policies by the ECB need to be consistent with the primary mandate of price stability, and its operations need to comply with the concepts of market neutrality and the application of appropriate risk controls. More importantly, central bank policies that transmit to the real economy through the bank lending channel have no effect on the development of patented “green” technologies because banks do not materially contribute to innovation in new technologies,” the paper says.

The European Securities and Markets Authority (ESMA) has told the International Sustainability Standards Board (ISSB) that its draft standards should “not result in confusion for investors” by allowing a free-for-all on sustainability metrics and disclosures.

In a comment letter to the ISSB dated July 13, the European regulator laid out five recommendations concerning the Board’s exposure drafts for sustainability-related and climate-related disclosure standards. The public consultation period on the two standards closed on July 29.

First, ESMA proposed that the ISSB clarify the definition of “sustainability-related matters” in the standards. Second, it recommended that the language used to describe “materiality” in the context of disclosure be used consistently throughout the standards. Third, it suggested that entity-specific metrics and disclosures “should be accompanied by adequate disclosures” to prevent investor confusion. Fourth, it said that the ISSB should consider how sector-specific guidance produced by the Sustainability Accounting Standards Board (SASB) could be incorporated in the climate-related disclosure standard. Fifth and finally, it floated the idea of supplementing the ISSB requirements with “some key additional details that are critical to achieve the comparability and relevance of reported information and improve the convergence with the draft ESRS [European Sustainability Reporting Standards] proposals.”

The European Insurance and Occupational Pensions Authority (EIOPA) released guidance on how insurers should go about incorporating customers’ sustainability preferences when selling long-term savings products.

The guidance, published July 20, should help firms comply with the Insurance Distribution Directive (IDD), a European Union law that governs how insurance products are marketed and sold throughout the bloc. The Directive comes into effect on August 2. 

Part of the law aims to make it easier for retail investors to put their money to work in support of a low-carbon, climate-friendly economy. Under the IDD, insurers must collect information from prospective customers in order to assess whether a given product is suitable for them. As part of this process, a customer can express their preference for a sustainability-focused product. The three types are: a product which invests a minimum proportion in environmentally sustainable investments as defined under the EU Sustainable Taxonomy; a product which invests a minimum proportion in sustainable investments as defined under the EU Sustainable Finance Disclosure Regulation; and a product that consider “Principal Adverse Impacts” on sustainability factors.

The objective of the sustainability preferences provisions under the IDD are to prevent insurers from selling ‘greenwashed’ products that do not further environmental goals.

In a July 11 speech Anil Kashyap, a member of the Financial Policy Committee (FPC) of the Bank of England (BoE), prompted financial institutions to “level up” their climate modeling capabilities. 

Speaking before the trade group UK Finance, Kashyap said the BoE’s recent climate stress test showed that modeling was “uneven” within and across participants. He said that firms must “own the responsibility” of making necessary changes to their practices and process, and that “starting sooner is better.”

Kashyap also said that many of the stress test participants relied heavily on third-party models, and that in some instances these were “not flexible enough” to handle the demands of the exercise.

He added that financial institutions require “a lot of non-standard information” — such as the carbon quotient of the products they sell and investments they acquire — to round out their climate risk management capabilities.

Kashyap’s core messages were reflected in the most recent edition of the BoE’s Financial Stability Report, published July 13. In a section on climate risks, the central bank said that the FPC “will monitor any risks to the financial system as a result of possible large-scale withdrawals of credit from particular sectors.” It explained that financial institutions’ collective interest is served by managing climate risks in a way that “supports the transition to net zero over time.”

On July 4 the UK Financial Conduct Authority (FCA) announced a delay to a consultation on sustainability disclosure requirements. The regulator initially intended to canvass public opinion in the second quarter. Now, it intends to unveil its proposal this autumn.

The FCA wants the requirements to establish a new labeling system for sustainable investment funds and to mandate entity- and product-level sustainability disclosures by asset managers.

The FCA said the proposal will allow it “to take account of other international policy initiatives and ensure stakeholders have time to consider these issues.”

On July 20, the FCA announced it had teamed up with the University of Oxford to build a new research hub for sustainable finance.

The Oxford Sustainable Finance Lab is scheduled to open later this year as a “safe space” to test and scale climate finance innovations, according to its founder Dr Ben Caldecott, Director of the Oxford Sustainable Finance Group.

The FCA’s ESG Division is joining the initiative to build new partnerships and collaborate on research opportunities, said Sacha Sadan, Director of ESG at the regulator.

On July 29, the FCA and the Financial Reporting Council — the UK’s regulator for auditors, accountants, and actuaries — published two studies on the climate-related financial disclosures of major publicly traded companies.

The FCA performed a quantitative analysis of the disclosures of 171 premium-listed firms and a more targeted, qualitative analysis of a 31-strong sample of these disclosures to measure their alignment with the Task Force on Climate-related Financial Disclosures (TCFD). 

This found that while over 90% of firms self-reported that they disclose in line with the TCFD’s governance and risk management recommendations, less than 90% said they had done so in respect to the strategy and metrics and targets pillars. Furthermore, the FCA found that some companies said they made recommended disclosures, but in reality these “appeared to be very limited in content.” The regulator said it “may take action as appropriate” to address these cases.

The FCA’s study also analyzed firms’ net-zero commitments. Though 80% of companies made net-zero statements in their annual reports, including a target date for achieving their goals, the regulator said that some of these were “not clear” and a number “risked being misleading.”

The Japan Financial Services Authority (JFSA) released guidance on climate-related risk management and client engagement on July 15. In an English-language summary, the JFSA encourages financial institutions “to accumulate their knowledge of climate change and understand the effect on clients of the evolution in technologies, industries, and natural environments caused by climate change.” It also tells them to help clients disclose their greenhouse gas (GHG) emissions and to support their decarbonization strategies.

On July 12, the JFSA released a draft ‘code of conduct’ for ESG data and evaluation providers. This list of principles is intended to guarantee the integrity of ESG data throughout the investment chain and improve the transparency of ratings providers. 

The code is structured to fulfill six principles: securing ESG data quality; developing necessary professional human resources; ensuring independence and managing conflicts of interest; improving transparency; establishing confidentiality; and improving communication with companies.

Once finalized, the code will be applied on a “comply or explain” basis, and Japanese financial institutions will be encouraged to express their support via public announcement.

The draft is out for public consultation until September 5.

The Reserve Bank of India (RBI) issued a discussion paper on climate risk management for financial institutions on July 27.

The document sets out good practices for banks and other regulated entities on climate governance, strategy, risk management, and disclosure. Among other things, the paper recommends that firms establish a Board-level committee or subcommittee to guide climate-related policy and oversee progress on climate-related targets. It also says senior management should have access to “suitable capabilities and experience” to handle climate-related risks.

On risk management, the RBI says firms should construct climate scenarios to gauge their exposures over the short, medium, and long term. It further recommends that companies produce climate risk indicators to quantify their exposure to physical and transition threats. Examples include emissions-intensive asset concentration and portfolio carbon footprint. 

The paper also encourages banks to set voluntary green funding targets to ramp up their financing to “certain identified sectors.”

Public comments on the discussion paper are welcome until September 30.

The Monetary Authority of Singapore (MAS) published its second sustainability report aligned with TCFD recommendations on July 28.

In a speech introducing the report, Ravi Menon — Managing Director of MAS — said the regulator was focused on four sustainability outcomes: a climate resilient financial sector; a vibrant sustainable finance ecosystem; a foreign reserves investment portfolio well-positioned for the low-carbon transition; and the decarbonization of MAS’s own operations.

Menon also underlined the importance of transition finance. “Where the industry needs to do better is in transition finance — to provide the funding support for companies that are not so green, to become greener. Last year saw just twelve transition bonds issued globally, amounting to US$4.4 billion,” he explained.

On July 26, MAS launched the Point Carbon Zero Programme with Google Cloud to accelerate and scale climate fintech solutions in Asia. Budding entrepreneurs are invited to submit ideas to tackle climate finance problems. One hundred will be shortlisted for further development and for testing by a 1,000-strong group of financial institutions. Participants will deploy their creations on Google Cloud’s purpose-built, open-source cloud platform.

The Chief Executive of the Singapore Exchange (SGX) said greenwashing is the “biggest threat” to the low-carbon transition in a July 19 speech.

Tan Boon Gin was speaking at an event on climate reporting in the Asia-Pacific. He recommended that regulators take three actions to combat greenwashing: make information available, make information comparable, and make information trusted.

“Singapore has a number of companies that excel in sustainability reporting. But there is also a long tail of companies that hasn’t [sic] done as well. We will focus in the coming year on closing this gap and helping more companies get up to speed,” he said.

The Financial Stability Board (FSB), the global forum for central banks and supervisors, published an update on its work addressing climate-related financial risks on July 14.

The report includes key areas of future work for financial authorities. These include expanding and strengthening climate scenario analysis and stress test capabilities.

“For financial stability purposes, further development of scenario analysis and stress tests will be needed, to develop a truly system-wide approach that covers key financial sectors, interdependencies between risks and systemic risk aspects such as indirect exposures, risk transfers, spillovers and feedback loops, including with the real economy,” the report said.

Financial regulators are also encouraged in the report to implement sustainability assurance, ethics, and independence standards so that climate-related financial disclosures can be trusted as reliable sources of information. 

The FSB added that more work is required to build out “common metrics” for financial stability analysis.

The Integrity Council, an independent standard-setter for carbon credits bought and sold in voluntary markets, published draft standards for high-quality carbon offsets and removals on July 27.

The Core Carbon Principles (CCP) establish the basic criteria by which carbon credits, carbon-crediting programs, and methodology types can be judged. The Council’s goal is for the CCP to boost the accountability of carbon credit suppliers and increase confidence in voluntary carbon markets.

A public consultation on the CCP is open until September 27.