EU leaders at risk of letting down taxpayers if «climate-finance doom loop» left unbroken

Globally recognised approach by Finance Watch can help policymakers thwart looming climate change-induced financial instability through prudential rules upgrade

Finance Watch today called on EU leaders not to miss the opportunity of the upcoming review of banking and insurance prudential legislation to properly integrate climate risk, doing their part where central banks have been leading so far.

Signed by Finance Watch Secretary General Benoît Lallemand and Head of Research Thierry Philipponnat, its two-page letter to EU policymakers proposes policy solutions to the doom loop whereby financial firms “feed a vicious circle, enabling climate change by financing fossil fuel-related activities despite the now universal recognition that climate change poses a major threat to financial stability.”

Addressed to top EU policymakers, including European Commission President Ursula von der Leyen, Executive Vice-President Valdis Dombrovskis, and Commissioner Mairead McGuinness, the letter outlines an urgent need to calibrate financial institutions’ capital requirements to reflect climate risk and protect citizens from the threat of another costly financial sector bail-out.

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Prudential regulation should not support nor penalise

Prudential regulation in its current form ignores the impact of climate change on financial stability, giving a de facto favorable, supportive treatment to fossil fuel exposures. Compounding this, the financial sector has been pushing policymakers for a green supporting factor, i.e. reducing capital requirements for “green assets”, with no evidence that such assets present less financial risk than others, thereby at the risk of creating a green assets bubble. Finance Watch agrees with financial supervisors that using prudential regulation for economic policy purposes would be “back-seat driving”, as it is the role of governments to give a direction to the economy.

Regulatory upgrade needed now, amend fossil-fuel exposure treatment in prudential regulation

The letter states that policymakers can quickly shore up the EU prudential framework simply by amending the capital requirements applied to fossil fuel exposures to align with basic risk management principles and ensure coherence within the Capital Requirements Regulation (CRR) for banks and Solvency II (SII) for insurance firms, treating “comparable risks in a comparable manner”.

Fold in disruption risk and exert judgment to tackle the issue

While it is now certain that climate change will destabilise the financial sector, measuring with any degree of precision its impact on financial institutions presents an impossible task for supervisors. This is particularly true of physical risk, given the lack of data inherent to a forward-looking event, but even more so of the biggest risk of all, disruption risk – now made familiar due to Covid – where climate change will severely affect the economy as a whole, and subsequently the financial system.

Tackling the climate-finance doom loop does not require modelling but action. Finance Watch argues that regulators already grasp the economics of the situation, and have the legal basis and the regulatory tools needed to intervene without waiting.

The call echoes the words of Janet Yellen at the recent Biden Climate Summit: «The thinking goes that because we know so little about climate risk, let’s be tentative in our actions — or even do nothing at all. This is completely wrong, in my view. This is a major problem and it needs to be tackled now”.

Finance Watch approach backed by leading groups

Outlined first in a June 2020 Finance Watch report, the “climate-finance doom loop” is increasingly recognised as a danger. The link between climate change and financial instability – and how to address it – was at the center of a 13 April report by the Climate Safe Lending Network in partnership with UNEP FI. They convened a panel of 50 banks, NGOs, academics, regulators and investors from the United States, Canada, European Union and the United Kingdom to study the matter. The panel ranked the Finance Watch solution the most impactful and feasible: moving from a quantitative to a qualitative approach whilst remaining within a strictly prudential, risk-based framework.

The Finance Watch letter suggests amendments that could be introduced to the Capital Requirements Regulation (CRR) and Solvency II during an upcoming review. These would go a long way towards breaking the climate-finance doom loop.

The letter says: “Given your mandate under Article 191 TFEU to combat climate change and take preventive action in the case of risk, we urge you to act now and bring a now-internationally recognised solution to a problem threatening our society.“