The Bank of England is delaying the inevitable on climate capital rules

June 16, 2021

Penalising dirty lending is necessary to ensure financial stability and support net-zero. 

While the regulatory reforms triggered by the global financial meltdown of 2007/08 have yet to be fully implemented, another major rethink of financial regulation is already underway. Climate change is the new systemic risk. Carbon is the new bubble. And fossil fuels are the new subprimes. In the face of environmental breakdown, the financial system is more precarious than ever.

Staring down the barrel of instability, regulators’ most effective and readily available tool is capital rules. A report by the Climate Safe Lending Network found that sustainable finance experts rated getting ‘tougher on buffers’ – increasing capital requirements for high-carbon exposures – as a particularly impactful and feasible proposal. Green capital rules would enhance the stability of banks and increase the cost of dirty lending, helping to break the so-called ‘climate-finance doom loop’ whereby finance and the climate continuously destabilise each other.

Under the Financial Services Act 2021, the Bank of England’s Prudential Regulation Authority is now explicitly required to have regard to the net-zero target when making capital rules. This legislation came just two months after the Bank received its new green mandate to support the government’s environmental objectives.

But the Bank is stalling. Pointing to a lack of data, it claims there is not yet a clear case for penalising dirty lending, and has focused attention on its new climate scenario analysis exercise launched last week. The exercise will not be used to set capital requirements, but is likely being viewed as a necessary prerequisite for potential climate-related changes to capital rules further down the line.

Scenario analysis was a popular policy at the recent Green Swan conference, which brought together an impressive line-up of academic, regulatory, and corporate heavyweights to discuss how the financial system can take action against climate change. But these new modelling exercises, aimed at measuring the financial system’s exposure to climate risks, could be doing more to delay rather than accelerate regulatory action.

Climate risks are characterised by ‘radical uncertainty’ – their complex, far-reaching, non-linear, and rapidly evolving nature pushes them beyond the realm of quantification, meaning that modelling exercises will never be able to accurately measure them. Ironically, this a key argument in the Bank of International Settlements and French central bank’s Green Swan book, which was the source of inspiration for the Green Swan conference.

Waiting for illusory numbers before taking action against the very real and immediate threat of environmental breakdown is deeply imprudent, and flies in the face of the Bank’s mandate to protect financial stability and support the government’s net-zero target.

When confronted with the prospect of catastrophic disruption, it’s far safer to be approximately right than precisely wrong. There’s no question that finance is facilitating environmental breakdown, which will in turn generate financial, economic, and societal breakdown. Waiting for inherently limited economic models to provide us with precise – yet probably inaccurate – numbers before designing an effective regulatory response is a dangerous way to go.

Green capital rules are no silver bullet – managing climate-related financial risks requires a systemic transformation of the economy that must be led by governments with the support of their central banks. But by failing to re-calibrate capital requirements now, the Bank is neglecting one the most powerful tools at its disposal to strengthen financial resilience and begin aligning the financial system with a net-zero economy, as required by its new green mandate.

Penalising and even limiting dirty lending is a necessary and inevitable next step for prudential regulation. With the International Energy Agency telling us that achieving net-zero requires no new fossil fuel projects, a full-blown ban on the financing of any such projects should also be on the table ahead of COP26.

Results from the Bank’s new climate scenario analysis, which won’t be available for close to a year, are not needed to start taking decisive regulatory action against fossil fuels and other environmentally harmful assets. You don’t need a meteorologist to know which way the wind is blowing. While waiting for a detailed forecast that holds little promise of accuracy, the Bank is ignoring a rapidly strengthening gale.