One of the clearest examples of a regulators’ intention to force action on climate-related financial risks and ensure entities have the capital resources to absorb their potential future losses from them, came from Bank of England Governor Andrew Bailey yesterday.
Speaking at COP26 in Glasgow, the Bank of England Governor laid out a shift in gears in domestic regulation in the UK for 2022, with climate risk a key focus.
The goal is to “ensure firms are identifying and addressing climate related financial risks.”
On which the Bank of England will take an “active supervision” approach, the ensure its “supervisory expectations on climate are met,” Bailey explained.
When and where progress on climate related financial risks is seen as lacking or insufficient, Bailey said the Bank of England, through its Prudential Regulation Authority (PRA), will request clear plans and if needed exercise its powers.
Here Bailey turned to regulatory capital requirements, which he called a key part of the toolkit the Bank of England has at its disposal through the PRA.
Capital requirements will help to “ensure that firms have sufficient resources to absorb future financial losses” including from climate risks, contributing to the stability of the financial system, he explained.
“We already expect firms to hold capital against material climate-related financial risks and our existing toolkit enables us to take action. But we recognise capital may have a bigger role to play,” Bailey continued.
He referred to the publication of the PRA’s climate change adaptation report last week, which as we explained had a significant focus on whether new or additional capital requirement charges may be needed as a result of climate change.
“Let me be clear. Regulatory capital can and should provide resilience against the consequences of climate change, namely financial risks,” Bailey said.
So to recap, the Bank of England Governor highlighted the need for firms to have sufficient financial resources to absorb their future losses from climate risk, while stressing the ability of regulatory capital requirements to provide this resilience.
If the amount of capital companies, or any other entity, is required to hold against its climate risks increases, one way to achieve that might be through the use of insurance and capital market products designed to improve capital adequacy under a climate risk related lens.
This could be through pure risk transfer, buying of insurance or reinsurance, perhaps hedging with derivatives, that is designed to sit there alongside balance-sheets and be ready to kick in when climate risk related disaster strikes, or climate related financial losses exceed a predetermined level.
But increasingly, it seems likely that there could be a whole new category of climate risk-linked financial products, which can act as assets that securitize and transfer climate related risk to the capital markets in order to bolster capital adequacy.
Rather like catastrophe bonds are used by some insurance and reinsurance firms, not purely for their risk transfer properties, but also acting as a capital tool, something that became increasingly prevalent for a time under Solvency II regulatory regimes.
The mortgage insurance-linked securities (ILS) market is also an interesting case, where a catastrophe bond like structure is used to transfer mortgage insurance risk to the capital markets, securing reinsurance, but really these structures are issued just as much for their capital benefits and to ensure they meet their Private Mortgage Insurer Eligibility Requirements (PMIERs).
If climate related financial risks are going to be dealt with through the disclosure of them and then capital requirements or charges applied against them, then climate risk-linked securities may be one way to achieve a transfer of this risk and regulatory capital burden, helping to build resilience but also enabling companies to finance their own transitions towards net-zero and a lower-carbon future.
Food for thought and we know of plenty of people working towards, or exploring, these kinds of instruments, seeing capital market financial products as one tool to respond to climate related capital requirements and to reduce climate risk on balance-sheets, as well as in portfolios of assets, both financial and also physical.
There is a very strong chance that as climate gets embedded into reporting and capital measures, in all walks of industry, finance and life, that a new asset class emerges which is akin to insurance-linked securities (ILS), but purely climate risk and capital focused and very possibly fully securitised and investable.