This article was authored by Martina Menegat.

Climate-differentiated capital requirements for financial institutions have been proposed as a method for ‘crowding in’ green investment by making it either cheaper to finance climate-friendly activity, or more expensive to finance harmful activity. The debate has been polarised between these two options: a ‘green-supporting’ factor or a ‘brown-penalising’ factor. Yet, things are not always simply green or brown, and the range of policy options is far more varied than this binary choice.

Capital requirements are cushions of capital that banks are required to hold in order to absorb losses, expressed as a percentage of deposits – with a reserve ratio of 20%, banks would need to keep 20% of all their deposits on hand to guard against losses. Adjusting the right amount of capital requirements is a delicate exercise. With a capital ratio fixed at 100%, banks would simply be piggy-banks, able to take in deposits but barred from lending money and investing in the economy. With undercapitalized banks, the risk is insolvency, which triggers expensive recovery interventions. Currently, under the Basel framework, banks  hold a minimum capital ratio of 8% based on their risk-weighted exposures.

The main argument for introducing climate-differentiation capital requirements is that climate change poses relevant, uncosted, risks for the financial system.

Central banks are increasingly committed to identifying, measuring, and assessing climate-related financial risks (CRFRs). The Governor of the Bank of England, Andrew Bailey, believes that stress tests and scenario analysis are the best tools to evaluate CRFRs. Yet, so far they have been incapable to help banks in adjusting their exposures to climate risks.

The main obstacle to accurate pricing of CRFRs is their ‘radical uncertainty’: even if we are pretty sure that a combination of CRFRs will materialise in the next future, there are no advanced methods for calculation. CRFRs are also endogenous to the financial system: the misalignment between the global financial system and Paris climate targets exacerbates the same risks that central banks are trying to measure.

According to Greenpeace UK and WWF UK, UK financial institutions have exposure to high-emitting companies for 1.8 times the country’s domestically produced emissions. Advocates of short-term action argue that patchy data are better than nothing. Hard rules on banks are thought to correct the ‘feedback loop’ between finance and climate, in turn reducing systemic climate risks.

Regulators are showing increasing interest in this topic. While the European Banking Authority is expected to publish its advice to the European Commission on the integration of sustainability in capital requirements by 2023, in the Canadian parliament there is already a proposed law to adjust capital requirements to climate risks generated by exposures to high-emitters.

However, proposals to change banks’ capital requirements have been harshly opposed by the financial industry and so regulators prefer to be cautious. The Bank of England has already examined the possibility to introduce a brown penalising factor, but identified a series of obstacles. Most notably, heightening capital requirements for profitable companies that are conducting brown businesses could destabilise the financial system. Conversely, easing requirements for green companies (the so-called green supporting factor) without accurately calculating their risk profile could create a green bubble.

Climate-related capital requirements need not be reduced to green-supporting or brown-penalising factors. The energy put into the debate is much wider. Academics and civil society organisations have formulated three proposals that are of particular interest.

First, economists have suggested combining a green-supporting and a brown-penalising factors. The simultaneous adoption of such factors will have positive effects on reducing global warming, and thus diminish physical risks for financial institutions. Yet, the same research found that, for example, combining a brown-penalising factor with green fiscal policies will be more apt in addressing financial stability concerns.

Second, other experts argue in favour of a climate systemic risk buffer. A buffer is an additional cushion of a bank’s capital that can be introduced to address exposure to systemic risks. Supervisors can apply a climate buffer on all banks that are particularly vulnerable to CRFR or on all assets that face high risk to be stranded.

Third, a coalition of NGO and CSO organisations has proposed to introduce a one-to-one capital or a 1250% risk weight rule on banks. In this case, banks would be required to hold an amount of capital at least equal to their exposures every time they finance new fossil fuel projects – which are at higher risks of becoming stranded assets in the light of national transition plans.

No single policy is a silver bullet. If introduced, climate-differentiated capital requirements will produce a small contribution to reducing the pace of global warming. It is also unlikely that a slight increase in capital requirements for high-emitter companies will disturb massively the financial system.

Opponents of climate-differentiation capital requirements are right in a sense: they are not the perfect instrument to deal with climate change. However, the perfect instrument simply does not exist. Instead, we have a toolkit of regulatory instruments at our disposal. We need creativity and debate to face the climate crisis.