FCA and PRA respond to the climate change challenge

The FCA and PRA published reports on the challenges for financial institutions to adapt to climate change on 28 October. The regulators aim to address the risks and opportunities from how climate-related developments are identified and managed by firms. The Pensions Regulator (TPR) also set out guidance and the FRC’s adaptation report will be published later in 2021.

Adaptation reporting focuses on how companies change their strategy or activity in response to the impacts of climate change. This should not be confused with mitigating the risks of climate change itself, but these actions are often blurred into one as adaptation activity often goes hand in hand with mitigation activity.

FCA on how FS firms are adapting to climate change

The regulator provides an overview of its climate change strategy, the climate change risks to financial services firms and how the regulator is helping adaptations, the transition to net zero, mobilising capital, and embedding climate-related considerations across all FCA functions.

The FCA also notes that climate change involves all three of its statutory objectives:

Consumer protection
Consumers should be able to access green products and services. Providers must ensure that such products and services work as expected, and consumers are not misled. It stated that 'greenwashing' is a material risk and that firms offering green products and services should meet reasonable expectation of consumers.

Transparency
Investors need robust disclosures to inform their decisions and manage climate-related risks and opportunities. This supports effective price formation in the markets and the efficient allocation of capital. And the markets need to evolve to ensure climate-related risks can be managed effectively.

Competition
In terms of effective competition in the interests of consumers, innovation helps ensure that consumers' needs and preferences can be met, and will drive competition to develop more sustainable solutions. Transparency supports this, helping consumers be clear about their choices.

The report discusses the steps the FCA is taking and includes a timeline for major ESG publications up until summer 2022.

PRA responds to climate-related risks

The PRA looked at the relationship between the climate and the regulatory capital framework. It admitted that it is complicated to determine whether changes to the design, use or calibration of the existing capital framework are needed to address climate-related financial risks beyond what is currently in place.Further work and research will be needed.

To help inform this work, and to explore parts of the capital frameworks that are specific to the UK, the PRA has undertaken an initial review on this topic. This produced some key findings:

1 The PRA noted that capital can address the consequences of climate change, not the causes, because the regulatory capital framework is not the right tool. It stated that research demonstrates that the use of capital requirements as a tool to affect financing and investment decisions directly is unlikely to be effective unless calibrated at very high levels – which could catalyse unintended consequences.

2 There are gaps in climate-related financial risks both in estimating climate-related financial risks due to lack of relevant granular data or modelling techniques that can fully incorporate climate factors – capability gaps – and blind spots in capturing climate-related financial risks due to the design or use of methodologies in capital regimes themselves.

This means that existing frameworks might underestimate future climate-related financial risks.

3 Identifying and assessing the materiality of these gaps is complex. Regulators will have to consider the appropriate timeframes for capital with regards to climate change – including how to gauge different levels of urgency and risk.

4 Finally, the PRA concluded that further analysis and research is required, including on specific options. The regulator noted that there is no set way to address climate issues, but it is contributing to early thinking by providing a non-exhaustive sample of options to address gaps and continue its policy-making process.

The PRA also provided a high-level timeline of key publications.

What are the key takeaways for firms?

Financial services firms governed by these regulators should examine these reports closely to fully understand the implications of adapting to climate change. While these obligations remain in their early stages, firms cannot afford to risk being behind their peers as this poses a risk to commercial and reputational interests.

Climate-linked risks and opportunities only continue to grow – firms should seek to begin or continue their journey to prepare for and manage these changes.

The provided timelines signal the rapid shift towards quantifying climate risk. To find out how firms can use early regulatory signals on climate and ESG-linked risk to prepare for the future, contact Rashim Arora