The UK’s financial regulators have responded to the Government’s request for Climate Change Adaptation reports. The reports focus on the current and future predicted impact of climate change in relation to the regulators' functions, their proposals and policies for adapting to climate change, and an assessment of progress against previous commitments and targets.
In this article we look at the key themes and messages from the PRA and FCA, including evolving supervisory approaches.
The PRA report (PDF 1.48 MB) addresses its own ESG and climate risk strategies, together with two key themes:
- The risks posed by climate change to PRA-regulated firms — including progress made in managing these risks, the PRA's response to risks that have been identified and policy developments from 2022 onwards as a result.
- The relationship between climate change and the PRA's regulatory capital regime, observed deficiencies and future areas of focus.
The FCA report (PDF 959 KB) again covers the regulator’s own ESG strategy. It also focuses on:
- The climate-related risks to which financial firms are exposed and how they are addressing and adapting to them
- How firms plan to transition to net zero and the role of capital mobilisation in financing climate change adaptation and climate change mitigation.
Risks to PRA-regulated firms and progress made
The PRA recognises that climate-related financial impacts pose a risk to its primary objective to promote the safety and soundness of regulated firms. An orderly transition to net zero will support this objective and the PRA has a role to support firms in realising the transition.
Supervisory Statement 3/19 (PDF 881 KB) (SS3/19) and the 2020 Dear CEO letter (PDF 528 KB) set out the PRA's supervisory expectations for the management of climate-related financial risk, and the Climate Biennial Exploratory Scenario (CBES) will provide an assessment of the largest UK firms' resilience to climate stresses.
The PRA notes a significant change since 2015 in the way firms’ leaderships recognise the risks associated with, and firms' responsibilities to, mitigating climate change. However, further progress is required, particularly in risk management and scenario analysis functions.
As it looks to 2022, the PRA has made it clear that it will exercise its full range of supervisory powers where firms are not deemed to have made sufficient progress on climate risk. These may include risk management- and governance-related capital scalars or capital add-ons and the use of s166 ‘Skilled Person' reviews.
Climate and the regulatory capital regime
SS3/19 requires banks and insurers to consider the impact of all material climate-related risks in the ICAAP or ORSA process. However, the PRA notes that these frameworks are only partially adequate in capturing the effect of climate risk on a firm and identifies the following gaps and possible solutions:
- Capability gaps — firms may lack sufficiently granular data, or appropriate modelling techniques to reflect relevant climate variables. Data may also be lacking for the purposes of risk management and business planning.
Solutions: calibration of models may be possible and appropriate, depending on the availability of data in the sector. The PRA may provide guidance on calculating risk-weighted assets (for banks) or modelling climate risks (for insurers). Firms with significant weaknesses may have additional add-ons. - Regime gaps (microprudential) — there may be gaps relating to firm-specific exposures, leading to the materiality or significance of a risk being understated at a granular level.
Solutions: frameworks may be amended to better capture climate-related risks at a granular level, e.g. by bank, by introducing more explicit forward-looking calculation requirements. Existing supervisory calculation values may be modified to incorporate climate risk, including changes to treatment of items in the calculation methodology e.g. collateral or securities. For insurers, internal models may be required to forward-project climate risks. - Regime gaps (macroprudential) — there are systematic weaknesses in forecasting the effects of climate change. The insurance sector does not have a system-wide capital buffer scheme to mitigate such weaknesses.
Solutions: potential changes to the systematic regulatory supervisory cycle to better address climate risk. A system-wide rate or buffer may be implemented, to be escalated over time, based on net zero transition and physical risk realisation.
In 2022, the PRA will develop its approach further, including:
- Determining whether changes are best enforced through changes to internationally-driven or domestic Pillar 2 requirements.
- Determining what changes are required to insurers' Solvency Capital Requirement (SCR) calculations.
Risks to FCA-regulated firms and consumers
The FCA identifies a “broader risk of financial loss for consumers where firms do not sufficiently consider climate risk”, whether through the physical effects of climate change on asset values or through loss of money or access to products where firms fail to adapt to the evolving policy environment. Harm may arise in varying degrees across different sectors and the report considers these sector specificities. It also considers the opportunities that may emerge for firms.
Transparency will be critical to supporting market integrity through the transition. Climate-related disclosures will enable all investors to make informed decisions and the FCA is keen to promote globally consistent standards – key to this is alignment with Task Force on Climate-related Financial Disclosures (TCFD) recommendations.
Market infrastructure and frameworks will also be important. Liquidity in secondary markets must be maintained and market mechanisms will need to adapt to enable firms to manage the impacts of climate risk.
Transparency and efficient markets will support effective competition, driving growth, innovation and improved standards, which can lead to better outcomes for consumers.
Net zero
Projects considering net zero will forms a significant part of the FCA’s sustainable finance work programme going forward. These include:
- Transition plans – working with HM Treasury to encourage and support firms in publishing net zero transition plans
- Net zero investor stewardship – the FCA will continue its work as part of the Stewardship Regulators Group considering issues such as how shareholder voting can drive positive change
- Research on capital mobilisation – see more below
- Innovate Digital Sandbox – work to develop solutions to ESG data and disclosure issues will start in Q1 2022.
To address the challenges facing firms in developing net zero commitments, the FCA has set out the following principles:
- Appropriate - firms and listed companies should set net zero commitments and targets that are appropriate to their business models. These should be supported by suitable resourcing and governance arrangements
- Achievable - firms and listed companies should set net zero commitments and targets that are realistic and feasible. Consumers and investors should be able to understand to what extent commitments are reliant on actions by other parties.
- Accountable - firms and listed companies will benefit from putting in place net zero targets to measure progress against their commitments
Capital mobilisation
The report considers the central role that financial services can play in the transition to net zero and adaptation in helping capital owners choose suitable investments.
Reasons for inefficient allocation of capital include negative externalities, policy uncertainty, misaligned incentives, information inadequacies, behavioural biases and decision-making considerations. These could harm both consumers and market integrity and the FCA notes the importance of the financial services sector being able to “efficiently and accurately match capital with the needs of a climate-resilient real economy”.
The report looks at different sources of funding, climate transparency and pricing, climate risk management and the role of derivatives and other initiatives. It also notes the positive impact of ESG and sustainability considerations becoming more important to investors.
Supervisory approach and timelines
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In 2022, all elements of the supervisory review cycle will include consideration of climate-related risks and will be complemented by one-off exercises such as the CBES.
- Management and relevant boards and representatives must ensure they remain aware of and are able to demonstrate their assessment of the climate-related risks facing their firm and plans to mitigate these risks.
- Where firms' responses are deemed deficient, the PRA will consider using its expanded list of powers, which may include risk management- and governance-related capital scalars or capital add-ons and the use of s166 ‘Skilled Person' reviews.
- The PRA will take a proportionate view, but size of a firm may not be the sole appropriate measure for determining a risk management approach. Small firms may have material or significant climate risk exposures - for these firms, the most appropriate approach may be similar to that for a medium or large regulated firm.
- An assessment of plans for meeting the requirements of SS3/19 will be included in the supervisory cycle for all firms. This will include assessment of responses to PRA questionnaires, information processed as part of management reporting processes and, where relevant, the outcome of the CBES.
- For larger firms, the process for compiling ICAAP or ORSA regulatory returns will be reviewed. The review will consider how firms have embedded climate-specific risk considerations in calculating their regulatory capital requirements and how they have gained confidence that all material climate considerations are included. The relevant SMF holder will be responsible for presenting this information to the PRA. Other firms will be included on a proportionate basis.
- The PRA will review disclosures made at the end of 2021 in line with the expectations set out in SS3/19. Further regulatory expectations may follow.
Areas for further communication in 2022 include:
- Regulatory capital - including whether the regulatory capital regime requires modifications to address climate-related risks.
- Regulatory returns - the PRA will consider what regular data supervisors could require from firms and if this should be collected via regulatory returns. If actioned, a consultation will be published.
- Scenario analysis - pending the results of the CBES, an update on future climate scenario exercises will be provided.
- Transition plans - the UK government's Roadmap to Sustainable Investing notes that the Sustainability Disclosure Requirements (SDR) will require disclosures on transition plans. The PRA will communicate further how these plans will be integrated into the supervisory cycle.
ESG developments expected for the rest of 2021 and 2022 include:
- Creation of an ESG Sourcebook to (i) clarify for regulated firms which rules apply to them and (ii) embed ESG in FSA supervisory and enforcement practices.
- November 2021 – publication of a Discussion Paper (PDF 485 KB) on the Sustainability Disclosure Regime and product labels.
- December 2021 – publication of final rules for TCFD-aligned disclosures for a wider scope of listed issuers and for asset managers, life insurers and FCA-regulated pension providers.
- H1 2022 – response to feedback received on the ESG and Capital Markets consultation (CP21/18).
- H1 2022 – engagement with stakeholders on promoting well-designed, well-governed, credible and effective transition plans.
- Spring 2022 – feedback on the November 2021 Discussion Paper and consultation on the resulting proposals.
- Summer 2022 – publication of the first FCA TCFD-aligned report considering the FCA as an operating entity and as a regulator. This will sit alongside the Annual Report.
Supervisory work is likely to focus on:
- Governance – a firm’s governance around climate-related risks and opportunities
- Strategy - the actual and potential impacts of climate-related risks and opportunities on a firm’s businesses, strategy, and financial planning where such information is material
- Risk Management - how a firm identifies, assesses and manages climate-related risks
- Metrics and Targets - the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.
The FCA will use its regulatory and supervisory tools to:
Oversee how firms design, deliver and disclose on sustainable finance products, where appropriate challenging on how well the ESG characteristics of products and services align with sustainability claims and meet clients’ and consumers’ evolving needs and preferences
- Oversee compliance with regulatory requirements related to sustainable finance, including implementation of new TCFD-aligned disclosure rules
- Assess the extent to which firms are effectively managing the risks and opportunities from climate change and the transition to a low carbon economy, and integrating these considerations within their culture and governance frameworks. This engagement is expected to scale over time to also consider how firms are managing broader sustainability risks and opportunities.
- Assess the extent to which firms are supporting the transition to a net zero economy. Where firms have set climate related targets or made net zero commitments, the FCA will consider delivery plans to achieve them.
- Hold firms to account if they fail to meet the expected standards.
In addition to these activities, the FCA is considering new areas of focus for future policy work to embed net zero and climate considerations.
