The ingredients for climate-related capital requirements

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.


COP27: finance day preview

COP27 is upon us. The first day saw UN Secretary General Antonio Guterres warn the world that "we are fighting for our lives and we are losing... we are on a way to climate hell", setting out the stakes of these talks, in addition to raising the pressing loss and damage issue.

Finance day is taking place tomorrow, on Wednesday 9th November. As accredited observers, GEFI have been working with our partners to curate events in the Blue Zone featuring our co-founder Omar Shaikh, who is out in Sharm El-Sheikh. As most of our audience will be tuning in online, we have given times in GMT. Local time (EET) is GMT+02.

Here is a selection events and programmes highlighting the best of finance at COP27.

We recently launched our Path to COP28 campaign. Join the campaign to get an early start on next year's key summit, and deliver finance for climate action. Find out more now.

 


GEFI launch Path to COP28 campaign

Leading financial institutions came together in Dubai this week for the launch of our ‘Path to COP28’ campaign to finance a greener global economy. The campaign features a number of partners, including the Dubai International Financial Centre (DIFC), which hosted the event. The COP28 summit in Dubai will be key to the  success of Glasgow’s COP26

The launch explored the role of the finance sector in the transition to a low-carbon and climate-resilient economy in the run-up to the global climate change summit in Dubai in November 2023. It saw the presentation of a new report into green sukuk, an Islamic finance product analogous to bonds, our new SDG Insight Series, and the Tayyib framework, designed to integrate impact with Islamic finance. Find out how to join the campaign.

While COP27 in Sharm El-Sheikh is just a month away, COP28 will see many financial institutions make major progress reports on and updates to the commitments they made at COP26 last year. At the Glasgow summit, many signed up to the GFANZ agreement led by former Bank of England Governor Mark Carney and made individual net zero commitments.

Our campaign is designed to encourage banks, asset management firms and other financial companies to demonstrate their commitment to the climate agenda, building upon the success of its  Path to COP26 campaign. It will consist of a series of activities and events, including a report on the challenge public sector pensions face in achieving net zero.

According to the United Nations Environment Programme Finance Initiative, the climate transition will require additional investment of at least $60 trillion from now until 2050 – around $2 trillion every year – meaning private sector commitments are vital to tackling the climate crisis.

And bold climate action could deliver at least US$26 trillion in economic benefits through to 2030, compared with business-as-usual, a report from the Global Commission on the Economy and Climate found.

David Pitt-Watson, Visiting Fellow at Cambridge Judge Business School and former President of United Nations Environment Programme Finance Initiative (UNEP FI) said that “As part of the Glasgow Financial Alliance for Net Zero (GFANZ), the finance industry set big aspirations. At COP26 in Glasgow, $130 trillion of invested assets signed up to the GFANZ, enough to fund the transition. COP28 in Dubai is where we find out how far these financial institutions have been able to deliver.”

He added that “finance, indeed our entire economic system, depends on climate stability. From COP21 in Paris in 2015, investors have urged policy makers not to delay in taking tough action. Together with global political leaders, the finance industry must play its part in creating and funding sustainable commerce. If it can, the future can be bright. If not, the alternative is catastrophic for us all.”

Graham Burnside, Senior Advisor to the Global Ethical Finance Initiative explained that “our Path to COP28 campaign seeks to encourage and support financial institutions in transitioning from commitment to actual implementation, measurement and reporting”, going on to point out that “finance can be a force for positive change” and asking for “organisations from across the globe to sign up to our Path to COP28 campaign to help us assist the financial sector to commit to practical efforts to tackle climate change.”

Arif Amiri, Chief Executive Officer of Path to COP28 host partner DIFC Authority said “DIFC and GEFI are delighted that the financial services sector is the first industry to launch a programme that aligns with the UAE government’s COP28 agenda.”

He added that “DIFC is perfectly placed to be host financial centre for the Path to COP28 programme given the progress we have already made and will continue to make on climate related matters with our clients. We are looking forward to working with GEFI and senior members of the local, regional, and international finance community to embrace this initiative and truly make a difference.”


DIFC Launches Programme with Global Ethical Finance Initiative Aligning with UAE’s COP28 Agenda

DIFC Launches Programme with Global Ethical Finance Initiative Aligning with UAE’s COP28 Agenda

  • Programme aligns with UAE and Dubai’s COP28 agenda
  • DIFC is host financial centre for 12-month path to COP28 programme, working with Global Ethical Finance Initiative (GEFI)
  • DIFC and GEFI invite members of global finance community to join the programme

 Dubai, UAE; 24 October 2022: Dubai International Financial Centre (DIFC), the leading global financial centre in the Middle East, Africa and South Asia (MEASA) region, today announced a year-long partnership with the Global Ethical Finance Initiative (GEFI), ahead of the United Nations Framework Convention on Climate Change’s 28th Conference of the Parties (COP28) taking place in Dubai.  COP28 will be held during November 2023 and see world leaders from the public and private sectors congregate to make progress on climate related matters.

With Dubai hosting COP28 and DIFC being a significant contributor to the sustainable economic growth of the Emirate, the Centre is leading by example and announcing their path to COP28 partnership just over 12 months before the event takes place.

DIFC and GEFI will drive change across the world’s financial industry relating to delivering Net Zero; unlocking Islamic Finance; financing nature and biodiversity; and financing the sustainable development goals. As host financial centre for GEFI’s Path to COP28 programme, DIFC will support a series of report launches, roundtables and community engagements during the next 12 months.

The partnership was launched at DIFC with a keynote presentation by Dame Susan Rice, one of the most influential women in banking, who Chairs the GEFI Global Steering Group. Dame Susan, the first woman to head a UK clearing bank, also Chairs the Financial Services Culture Board in the UK and enjoyed a seven-year term as a non-executive Director of the Bank of England.

Attendees also heard from the General Council for Islamic Banks and Financial Institutions (CIBAFI) Secretary General, Dr. Abdelilah Belatik, and Fajr Capital’s CEO, Iqbal Khan.

Arif Amiri, Chief Executive Officer of DIFC Authority said: “DIFC and GEFI are delighted that the financial services sector is the first industry to launch a programme that aligns with the UAE government’s COP28 agenda. DIFC is perfectly placed to be host financial centre for the Path to COP28 programme given the progress we have already made and will continue to make on climate related matters with our clients. We are looking forward to working with the GEFI and senior members of the local, regional, and international finance community to embrace this initiative and truly make a difference.”

Omar Shaikh, Co-Founder and Managing Director of GEFI said: “Our Path to COP28 campaign seeks to encourage and support financial institutions in transitioning from commitment to actual implementation, measurement and reporting. The maturity and foresight of the UAE government and DIFC as a world-class financial centre is critical to encouraging the regional financial sector to ramp up its environmental awareness and commitment towards achieving the COP targets.”

The partnership aligns with DIFC’s Strategy 2030 and reflects its progress on driving Dubai’s reputation as the region’s leading sustainable financial hub. This is being achieved through its chairmanship of the Dubai Sustainable Finance Working Group (DSFWG) which was established in 2019.

The Path to COP28 initiative also complements the recent launch of the DSFWG self-assessment tool for measuring the maturity of Environmental, Social and Governance (ESG) policies and practices in companies.

GEFI’s previous Path to COP26 campaign was supported by the City of London Corporation and brought together several signatories, including 20 financial institutions representing £2 trillion in assets, to drive finance for positive change at the Glasgow COP.

Members of the finance community can find out more about the Path to COP28 – and register their interest to be involved – on difc.ae.

Ends-

 

About Dubai International Financial Centre

Dubai International Financial Centre (DIFC) is one of the world’s most advanced financial centres, and the leading financial hub for the Middle East, Africa and South Asia (MEASA), which comprises 72 countries with an approximate population of 3 billion and an estimated GDP of USD 8 trillion.

With a close to 20-year track record of facilitating trade and investment flows across the MEASA region, the Centre connects these fast-growing markets with the economies of Asia, Europe and the Americas through Dubai.

DIFC is home to an internationally recognised, independent regulator and a proven judicial system with an English common law framework, as well as the region’s largest financial ecosystem of almost 30,000 professionals working across over 4,000 active registered companies – making up the largest and most diverse pool of industry talent in the region.

The Centre’s vision is to drive the future of finance through cutting-edge technology, innovation, and partnerships. Today, it is the global future of finance and innovation hub offering one of the region’s most comprehensive FinTech and venture capital environments, including cost-effective licensing solutions, fit-for-purpose regulation, innovative accelerator programmes, and funding for growth-stage start-ups.

Comprising a variety of world-renowned retail and dining venues, a dynamic art and culture scene, residential apartments, hotels and public spaces, DIFC continues to be one of Dubai’s most sought-after business and lifestyle destinations.

For further information, please visit our website: difc.ae, or follow us on LinkedIn and Twitter @DIFC.

 

For media enquiries, please contact: 

Omar Nasro | ASDA’A BCW
+9714 450 7600
omar.nasro@bcw-global.com
www.asdaa-bcw.com | www.arabyouthsurvey.com

Rasha Mezher | Dubai International Financial Centre Authority
Consultant, Marketing & Corporate Communications
+97143622451
t-rasha.mezher@difc.ae


On the Path to COP28: how we got here, and what to expect for finance

Our Path to COP28 campaign is building momentum for climate action from finance at COP28, and we will launch the campaign on 24 October in Dubai.

While COP27 in Sharm El-Sheikh is just a month away, COP28, taking place in Dubai in 2023, will see many financial institutions make major progress reports on and updates to their COP26 commitments. Our campaign builds upon the success of the prior Path to COP26 campaign to coordinate the finance sector ahead of this crucial summit.

In this blog, we take a look at what COP is, the role of finance, some of the key milestones along the path to Glasgow, and what to expect in Sharm El-Sheikh and Dubai.

What is COP?

COP stands for Conference of the Parties to the United Nations Committee on Climate Change. COPs are where the world comes together to agree on climate action, on how to mitigate climate change and adapt to it. As Manuel Pulgar Vidal, the COP20 President from Peru told us at our 2021 summit, this is no mean feat, as COP is “a multilateral process, with almost 200 countries: so everybody counts”.

Finance at COP

But what does all this mean for the financial industry? The early COPs like Kyoto were focused mainly on getting governments to agree on the basics of climate science, and what the targets for carbon emissions reduction should be in order to prevent or minimise.

Since then, attention has shifted increasingly towards action, looking at how we actually achieve the targets that the political process produces. One core component of this is finance. Most agree that addressing climate change requires significant transformation of our economies, particularly around the energy sector. Creating new industries and reshaping existing ones requires investment; while governments can provide some of the funding, the sheer scale of the challenge means that private finance must play a significant role. Since COP21, finance has been playing an increasingly important role at the summit.

The history of COP

COP1

The first summit, COP1, took place in Berlin in 1995. The foundation for the summit, and for the UN’s climate work, came from the Earth Summit in Rio in 1992. Presiding over the summit was Angela Merkel, Germany’s Environment Minister at the time.

COP3

A landmark early achievement of the COP process was the signing of the Kyoto Protocol at COP3 in 1997. The agreement set the groundwork for climate diplomacy, and was refined at subsequent COPs. However, key emitters such as the US withdrew from the treaty, and it took until 2005 to come into force.

COP6

COP6 at the Hague in the Netherlands saw a crucial issue come to the fore: paying for climate mitigation and adaptation in developing countries. Lack of agreement over this central question led to the collapse of the talks.

COP15

In 2009, COP15 in Copenhagen saw massive protests and was generally regarded as a failure. Many criticised the summit for not producing an ambitious, legally binding agreement in line with scientific recommendations. Others felt this was never a likely outcome given political considerations.

COP16

A solution to the “who pays for climate action?” question was agreed at COP16 in Mexico: the $100bn Green Climate Fund for developing countries. More than 10 years on, this has still yet to be delivered: the failure to do so has harmed trust in the process. There has been disagreement over how much public and private finance should contribute, and the recipients of funding.

COP21

In 2015 in Paris, COP21 saw the signing of the Paris Agreement, and the first real participation of private finance. The agreement represented a consensus that addressing climate change requires significant economic transition, particularly in the energy sector.

As finance is key to economic transition, the agreement included international mechanisms to promote climate-friendly finance, carbon trading, technology transfer and adaptation to climate change impacts. It also set the stage for the Taskforce on Climate-related Financial Disclosures, or TCFD, which has made its way into law in several countries in the years since, and significantly boosted climate bonds.

A notable contribution from private finance was a major petition to governments to commit to climate action: prior to that it was “assumed that capital markets opposed such regulation”, according to David Pitt-Watson, Chair of UNEP FI during the summit.

COP26

COP26 in Glasgow, saw the most significant progress since Paris, with the signing of the Glasgow Climate Pact. It still received a mixed reception from climate advocates, many of whom felt the agreement did not go far enough on securing binding targets, such as the last-minute amendment to “phase down”, rather than “phase out” coal. Arguably the most significant commitment was that made by all nations to come back before COP27 with enhanced emission-cutting pledges.

Nonetheless, the summit did see greater recognition than ever, from all across society, of the perils of climate change. One aspect of this was more involvement from financial institutions. The Glasgow Finance Alliance for Net Zero, or GFANZ, was launched, aiming to unite many existing initiatives, while individual financial institutions from around the world made net zero commitments of their own.

The future of COP

COP27

At COP27, in Sharm El-Sheikh, success is likely to be judged on four core areas: Mitigation, Adaption, Climate Finance and Loss and Damage. A key focus across the summit is likely to be issues for developing countries – as the COP process is driven by the host country’s diplomatic service, key themes often reflect that country’s priorities. On the finance side, we expect to see updates on potentially strengthening GFANZ, progress reports from financial institutions and a focus on nature and the need for nature-based solutions to climate change.

COP28

COP28 in Dubai will see the results of the first major stocktaking on the Paris Agreement. The process began at COP26, and will conclude in Dubai. This process is likely to be mirrored in the private finance side, as financial institutions provide results on their COP26 commitments, and update them.

Our Path to COP28 campaign will drive action from finance at COP28, and launches on 24 October in Dubai.