The latest consultation issued by the Prudential Regulation Authority (PRA) could lead to lenders incorporating the climate-related risks of borrowers into their internal capital adequacy assessment process (ICAAP). This would have a direct impact on the regulatory capital lenders need to assign to each loan they make. Borrowers need to be aware that this could have a significant impact on both the cost of borrowing money and the availability of finance.
The PRA is proposing these changes as it wants to ensure UK banks are prepared to manage the risks associated with climate change. It also wants to encourage lenders to play their part in supporting the economy through the allocation of finance aligned with the transition to net zero.
What is regulatory capital and why is it relevant to borrowers?
Lenders are required to hold sufficient regulatory capital to ensure they can cover unexpected losses. Each time a lender advances a loan to a borrower they must determine how much regulatory capital must be assigned to that loan – known as a capital adequacy assessment. As there's a cost associated with assigning regulatory capital, this has a direct impact on the size of the loan a lender is willing to make, as well as the interest rate payable by the borrower.
Currently, lenders consider a variety of factors when assessing how much regulatory capital needs to be set aside for each loan they make. These include data points on the perceived credit risk of the borrower, size and duration of the loan, and whether interest will be paid on a fixed rate or variable rate.
Climate-related risks – which the PRA defines as including risks relating to the transition to net zero – are not currently part of this regulatory capital calculation. But the latest proposals from the PRA show that this could be about to change.
What is the PRA proposing?
On 30 April 2025 the PRA and wider Bank of England published CP10/25 - 'Enhancing banks' and insurers' approaches to managing climate related risks - update to SS3/19'. This consultation is intended to update the PRA’s supervisory approach and provide greater clarity on the outcomes expected of lenders in their management of climate risks.
According to the PRA: “Firms need to be able to demonstrate that the financial risks from climate change are appropriately considered within their internal capital adequacy assessment process (ICAAP).”
The PRA proposes that lenders must demonstrate how climate risks (including risks related to the transition to net zero) are part of their capital adequacy calculations, and that these should be “embedded into existing frameworks” when approaching internal capital adequacy:
- The PRA proposes that a climate scenario analysis (CSA) is included in lenders’ ICAAP process and that lenders document and be able to demonstrate how the CSA informed their decision making in respect to capital (section 2.47)
- The PRA would like to see the CSA embedded into existing frameworks for lenders’ approaches to internal capital adequacy (section 2.85)
- Lenders should be able to provide information about how they have determined the climate-related risks in their ICAAPs, including methodologies, assumptions, judgements, etc (section 2.84)
- The PRA hopes that ICAAPs will capture a more complete consideration of climate-related risks (section 2.85)
Impact of factoring climate risks into the regulatory capital framework on borrowers
If lenders must allocate a greater amount of regulatory capital for a loan to a borrower with poor environmental credentials, this will have a direct and proportionate impact on the cost of credit:
- Lenders would have to charge more for such loans or may choose not to make the loan at all
- Borrowers should be aware that if they have poor environmental credentials or don't have a credible transition plan, it's possible that lenders may look to reduce their exposure
In 2024, our survey of mid-market lenders showed that 93% of lenders said they believed regulators may introduce a requirement to integrate environmental considerations into a bank’s internal capital allocation models for loans. The proposals in the CP10/15 consultation could make this a reality.
Environmental credentials to form part of credit risk assessments
CP10/25 also proposes that climate-related risks, including transition risks, should be part of the credit assessment process for lenders:
- Lenders should have clear processes and policies to “identify, measure, monitor and mitigate climate-related credit risks, including integrating climate considerations into credit risk assessments, evaluating climate-related risks across the credit life cycle and evaluating how these risks may impact their ability to recover loans” (section 2.91)
Many lenders already factor in a borrower’s environmental credentials into their credit risk assessments. In our 2024 survey of mid-market lenders, 54% of lenders said that a business’s environmental status and/or its ability to transition to net zero influenced their credit risk assessment always or most of the time. This is driven by lenders’ own sustainability targets and disclosures, and their desire to reduce the emissions produced by their mid-market borrowers. Virtually every large bank has made a commitment for their balance sheet to be net zero by 2050 by reducing the amount of carbon emissions they finance (scope 3 emissions).
The PRA would now like to see lenders formalise climate-related risks into their credit risk assessments. Possible key impacts of this are:
- This will add to the upwards pressure on the cost of borrowing for firms with poor environmental credentials
- Given that a high-emitting borrower directly impacts the emissions disclosure and net-zero transition of their lenders, mid-market firms should be aware that some lenders may choose to avoid high-emitting firms altogether
The PRA will apply proportionality
The PRA intends to apply the proposals contained in CP10/25 in a proportionate manner, depending on the magnitude of the climate-related risks lenders face.
Mid-market borrowers are served by a variety of lenders, including the large retail banks, challenger banks, debt funds and asset-based lenders (ABLs), with the large retail banks leading the way in terms of transition planning and emissions disclosures.
However, these proposals could be a pivotal moment for mid-market borrowers. Should climate-related risks be integrated into lenders’ capital adequacy models, borrowers will need to pay attention to their own environmental credentials. If they don't, they may risk paying higher interest rates or face reduced access to capital.
We help firms develop and communicate their strategy in relation to environmental, social and governance (ESG) and climate-related risks to lenders.
For more insight or guidance, contact Jon Bramwell.
