Banks’ capital requirements for the climate: Let’s ask the right questions

For several years now, the idea of using capital requirements for environmental purposes has been gaining ground. But before this can happen, however, several questions about such requirements need to be resolved, particularly as regards the instrument to be used and the objective to be achieved. Michel Cardona from I4CE has released this OpEd available on Euractiv

In order to prevent crises and deal with unexpected losses, banking supervisors require banks to provide sufficient capital: the riskier assets a bank holds, the higher the capital requirements. The idea that these requirements should be used to combat climate change has been gaining ground for several years, and the European Commission has mandated the European Banking Authority to investigate it.

Before we get to that point, however, the people and institutions that support the use of these climate requirements will have to answer several questions. The question of the instrument to be used, of course, as the current debate is polarized between the Green Supporting Factor, which would lower the capital requirements for so-called “green” activities, and the Brown Penalizing Factor, which would increase them for “brown” activities. But also – or rather first of all – the question of the objective: why in concrete terms do we want to use the capital requirements?

If the objective is to protect banks, the so-called “physical” and “transition” climate risks of each asset class must be precisely measured and incorporated into the risk factor applied to it. It must be noted that we are currently unable to calculate precisely the level of climate risk attached to each asset class, for at least two reasons. The first is the great diversity of possible trajectories for combating global warming, so we cannot rely on historical data to make the future more likely. The second is the great difficulty in translating into short-term risk measurement instruments risks that are by nature medium- to long-term.

The use of capital requirements therefore strongly resembles a technical impasse, at least momentarily, to strengthen banks’ security against climate risk. For this objective, it is better to turn to other mechanisms such as climate stress tests or macro-prudential tools.

If, on the other hand, the objective is to finance the low-carbon transition, to divert financial flows  from “brown” activities and/or to channel them towards “green” activities, then the current impossibility of precisely measuring the climate risk at the level of each asset is no longer an obstacle. All that is needed is to know how to identify the “green” activities that one wants to support and/or the “brown” activities that need to be progressively reduced, which can be done by setting up activity classifications such as the European taxonomy.

Using capital requirements, i.e. regulations initially dedicated to financial stability, to better finance the low-carbon transition is nevertheless a much less consensual objective. And this raises other technical questions: at what level should the adjustment be made so that it is effective without disrupting the banks’ financing of the economy? How can we ensure that this does not affect the financial soundness of banks?  How can “brown” activities be penalised while at the same time accompanying the necessary transformation of the most emitting companies? The Green Supporting Factor or the Brown Penalizing Factor each have advantages and shortcomings in meeting these challenges and our conviction, after analysing several available instruments that are not limited to these two, is that an instrument that addresses both “green” and “brown” assets would be preferable.

To overcome these difficulties, the solution probably lies in a decentralised system that leaves it up to each bank to set up an instrument adapted to its loan portfolio and the nature of its activity, with supervisors simply providing a general framework to be respected, setting a course and monitoring the banks’ progress. A decentralised system that would be similar, for example, to that set up by the European Commission for the automobile industry: the Commission sets a target for the gradual reduction of average CO2 emissions from cars sold during the year, monitors whether or not the various manufacturers meet this target, but leaves them free to choose how to achieve it.

Those promoting the use of banks’ capital requirements for the climate will have to provide clarification. Do they want to use them to protect banks from climate risks? Then they will face a major technical challenge, one that is potentially insurmountable to date. Is it to finance the low-carbon transition? They will also face technical challenges, but their biggest challenge will undoubtedly be political: convincing regulators that the best way to address financial stability is still to accelerate an orderly transition to a low-carbon economy.