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    ISDA Finds FRTB Results in Higher Capital Charges for Carbon Trading

    July 26, 2021

    The International Swaps and Derivatives Association (ISDA) published a paper that explores the impact of the Fundamental Review of the Trading Book (FRTB) on the trading of carbon certificates. The paper notes that FRTB would result in higher capital charges for carbon trading under the standardized approach to market risk, which could impair the ability of banks to act as intermediaries in the emissions trading system market globally; this is expected to have an adverse effect with respect to a key tool for policymakers to ensure a cost-effective transition to a carbon-neutral economy. The analysis suggests that including the lower risk-weight of 37% and the higher tenor correlation of 0.996 would result in a 60% reduction in capital requirements, based on the simplified example for a typical carry position of a bank.

    The ESG Risk and Capital Working Group of ISDA has developed this paper, which also investigates whether a more conservative treatment of carbon credit trading in the FRTB is justified from a risk perspective as ISDA believes it is important the regulatory treatment of assets is justified from a risk perspective. This is particularly important for carbon certificates, as inappropriate levels of capital would impact the functioning of this market and affect the willingness of institutions to invest in the transformation to a green economy. The results of the ISDA analysis suggest that FRTB in its current form unduly penalizes carbon-credit trading. The treatment of carbon certificates, as per FRTB, appears out of sync with the underlying risks in the following two key areas:

    • Risk-weight of carbon certificates. The results of the analysis suggest the risk-weight for carbon certificates under the standardized approach to market risk is set too high. Based on the estimated stressed-period volatilities of carbon certificates, ISDA believes a risk-weight of nearly 37% would be more appropriate. This is less than two-third of the 60% risk-weight currently prescribed by FRTB framework. Viewed in isolation (disregarding spillover effects to other parts of the portfolio), this would imply a lower capital charge of close to 40%.
    • Penalization of carry positions. For commodities with physical storage costs, fluctuations in such costs imply a carry position is not a perfect hedge. Consequently, FRTB imposes a correlation of 0.99 between spot and forward positions. However, carbon certificates are not typical commodities as there are no physical storage costs. Therefore, a much higher correlation for carbon certificates is appropriate. ISDA recommends setting a tenor correlation parameter (medium correlation scenario) for carbon certificates of 0.995-0.999, reflecting empirical observations.  An alternative to updating the tenor correlation parameter could be to extend the exemption for pure stock financing from the simplified standardized approach to the standardized approach. This would result in positions where a physical stock has been sold forward being excluded from the commodities risk calculation, which would function as an exemption for carry positions of carbon emission certificates.

    According to the ISDA Chief Executive Officer Scott O'Malia, in its current form, FRTB would lead to disproportionately high capital requirements for carbon certificates, which would constrain banks’ ability to support the global reduction of emissions. Ultimately banks will make their own decisions about the businesses in which they are active. However, if the regulatory framework penalizes them with unduly high capital requirements for the trading of carbon certificates, they will naturally retreat from that market. Policymakers tend to agree that carbon trading will be central to the success of the global drive toward net zero in the years ahead. Basel III must be appropriately calibrated to avoid thwarting progress on climate change.

     

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    Keywords: International, Banking, FRTB, Climate Change Risk, Carbon Trading, ESG, Basel, Standardized Approach, Market Risk, Regulatory Capital, Transition Risk, ISDA

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