As the regulatory policy framework for climate risk develops, a key consideration for banks is how climate-related financial risks are captured by prudential capital requirements. Supervisors have made clear that banks are already required to integrate climate risk into their existing prudential risk management frameworks as a cross-cutting risk, and to consider climate as part of their ICAAP – as they would any material risk. But it is evident that until data, classification and modelling capabilities develop, banks’ ability to capture climate risks will be limited. Scenario analysis and stress testing will help with assessing banks’ climate risk exposure, and the BoE and ECB are running supervisory exercises in 2021 and 2022 respectively. In the near term those exercises will not be used to set banks’ capital requirements. However, supervisors will increasingly use the Pillar 2 framework to ensure that banks adequately manage their climate risk exposures, which will eventually lead to climate risk-related capital add-ons for at least some banks.
These changes will in turn alter the capital cost of risk and have implications for capital planning. Looking forward, the EBA and European Commission will assess by 2023 whether to include climate risk-specific requirements in the bank capital framework. This means that it is unlikely that the Commission’s proposal for the next iteration of EU legislation on capital requirement (CRD6/CRR3) will include any climate risk-specific capital requirements. For the UK, the BoE has said that there is currently too much uncertainty about the nature of the risk and how existing measures will help mitigate it to be able to take a judgement as to whether climate risk-specific prudential tools are required. Irrespective of the position taken on how climate risk should be managed for prudential purposes, policymakers may decide to apply the prudential framework to create additional incentives for banks to support the transition to a net zero carbon economy. That said, the need for a scaling factor to accelerate the transition to net zero may have become less necessary since the introduction of the Green Asset Ratio (GAR) disclosure requirement for EU banks.