Banks hold capital to cover their losses and provide confidence to investors and lenders that they are viable and sustainable businesses. The amount of capital they hold is determined by the risks they face and the prudential regulatory framework within which they operate. 

As economies look to transition away from carbon-based assets to more sustainable forms of energy production or usage, significant financing may be required, including for potentially new and innovative solutions. 

While some will succeed with potentially good rewards, others will fail, and with losses typically borne by the finance providers, that may be a detriment to providing finance. Where there is financing, new and untested products tend to carry higher credit risk, so banks need to hold more capital.

“Climate change solutions are an essential part of the move toward the low-carbon economy,” says Rebecca Self, former CFO, Sustainable Finance, at HSBC and now Founder and Managing Director of Seawolf Sustainability Consulting. “Currently they often lack mainstream finance due to their different risk and return profile, when compared to existing technology.”

Promoting green lending using risk weights

Self believes one potential downside to the current prudential framework is that it does little to encourage financing of green assets: “It is possible it maintains the status quo when it comes to the energy mix in the economy and disincentivises sustainable innovations by new players,” she warns.

However, there is an argument that prudential capital rules could be used to encourage financing of products and services that help reduce or eliminate climate change. A measure in the Financial Services and Markets Bill currently before Parliament provides a basis for doing this. It will require regulators to have regard to “the need to contribute towards achieving compliance with section 1 of the Climate Change Act 2008 (UK net zero emissions target)” when undertaking their functions.

This could take the form of reduced capital requirements (lower risk weights) for green assets, or higher capital requirements (higher risk weights) for non-green assets. The risk weights would not reflect the actual credit and market risks of lending. But by changing the relative costs of green and non-green assets and the risk-reward trade-off, banks would be incentivised to lend to green assets.

There is precedent for reducing risk weights to achieve a particular lending outcome. Indeed, a lower risk weight for SME lending was originally introduced to limit disruption to the flow of credit to small businesses during the phase-in of stricter requirements following the 2008 global financial crisis.

However, a reduction in risk weights is not without its risks. The principal one is that it results in lower capital requirements, which leads to a bank holding insufficient capital for the risks it runs. For example, a house with heat pumps and solar panels may be green, but if it’s built on a flood plain it carries a heightened risk from climate change. This would undermine the principal objective of prudential supervision. 

The flip side is that lower risk weights lead to a greater and more stable supply of financing. If the regime is implemented for diversified banks with small concentrations to green assets, undercapitalising those assets should not threaten the bank as a whole. 

The use of higher risk weights to penalise non-green assets increases capital, which would both help subsidise lower risk weighted green assets and support individual bank safety and soundness.

At the same time, an increase in the cost of lending for non-green assets may push that lending into the shadow banking realm, where the scrutiny of environmental and social issues may be much lower. In that sense it would not achieve the desired aim and may even be detrimental.

There is also a risk with this approach that it becomes a dangerous precedent for pursuing other public policy goals, which may be inconsistent with and undermine the prudential regulator’s primary objectives. 

There are also practical challenges in designing an effective regime, not least the absence of a UK taxonomy to clearly define assets that help reduce climate change. Not all green assets are obvious. Some offer sustainable alternatives to carbon based energy production (for example, solar and wind farms), others will reduce greenhouse emissions, while others may continue to generate or even increase emissions in pursuit of the development of green products. 

That’s also assuming that the definition of a “green asset” remains constant. The absence of a UK taxonomy suggests that in the first instance any regime would likely be narrowly targeted at clear and obvious green assets such as wind farms. However, that approach may fail to provide adequate incentives for new innovative assets that are as yet unproven. 

Green assets are just one aspect of the sustainability agenda. To be truly sustainable, incentive schemes should also take account of the effects on biodiversity or society, where trade-offs may exist. Take the example of a sea-based wind farm, it generates sustainable electricity but its construction has an environmental impact in terms of damage to the seabed. 

The complexity of a coherent capital framework – one that addresses these different outcomes and looks to manage their potential trade-offs while also delivering prudential soundness – cannot be underestimated.

Whereas the remit of prudential regulation covers only a part – albeit a significant chunk – of the economy, the government may be better placed to deliver an economy-wide solution, for example, by granting subsidies or turning to tax in the form of tax breaks or imposing a carbon tax to promote lending and investment. An ecocide law would be another option. Government measures may also improve the creditworthiness of green assets and reduce the risk of lending to new innovative solutions.

Regardless of the prudential capital rules, banks are taking action and new approaches are afoot – HSBC’s climate strategy to help clients reduce their emissions and scale up low-carbon solutions signals a move by banks to bolster their green credentials.

Regardless of the mechanisms that emerge, the PRA’s 2021 Climate Adaptation Report warns that the use of capital requirements as a tool to affect financing and investment decisions directly will likely fail unless calibrated at very high levels. “These levels could give rise to unintended consequences, such as the erosion of capital in the system or build-up of risks in other areas,” it warns. “Ultimately, regulatory capital cannot substitute for government climate policy.”

Simon Gibbs is a Financial Services, Banking and Insurance Manager at ICAEW