ESRB Report Examines Effective Tools for Carbon Emission Reduction

The report on bank capital regulation and climate change discusses whether and how monetary policy and financial regulation should take climate change and the associated risks into account. The report focuses on the bank capital regulation and examines that the climate change could be relevant for bank regulators in two possible scenarios. In the first scenario, climate change may expose the banking sector to financial risks that the current regulatory framework does not account for. Prudential capital requirements based on historical default frequencies are unlikely to fully account for future physical and transition risks arising from climate change. In the second scenario, bank capital regulation may be proposed as a tool for tackling the consequences of climate change more broadly by supporting the transition to a low-carbon economy, as no global carbon tax has been implemented.

The report concludes that, while bank capital requirements can effectively address prudential risks arising from climate change, they are not likely to be the most effective tool for reducing carbon emissions. The report states that using capital requirements to address climate risks is similar to managing traditional risks. However, in contrast to traditional risks, climate risks pose novel measurement challenges, because historical data series contain limited information about future climate risks. Despite the recent progress in the form of climate stress tests and other research, more work needs to be done to understand the exposure of the financial sector to climate risks, some of which will materialize over a time horizon that exceeds the horizon usually considered for prudential regulation. The report also highlights that using bank capital requirements to discourage funding of carbon-intensive activities is less likely to be effective for two reasons. The first one states that, as long as activities with high carbon emissions remain profitable, removing loans that fund these activities from the banking sector may either be impossible or may require lowering capital requirements on loans with small carbon footprints below the prudentially optimal level, thus sacrificing financial stability. The second reason sates that, even if capital regulation can successfully remove dirty loans from the banking system, high-emitting activities will likely attract funding elsewhere as long as they offer a positive return to investors.  

The report suggests that bank capital requirements can play a supporting role by facilitating more direct policy measures. Carbon taxes, one such measure that can directly reduce the profitability of carbon-intensive investments, could be more effective to reduce emissions and the associated externalities. By ensuring sufficient loss-absorbing capital in the banking sector, bank capital requirements can help to facilitate the introduction of carbon taxes or stricter environmental regulation, which governments may be reluctant to introduce so long as the resulting revaluation of bank assets and the associated stranded asset risk could trigger a banking crisis.

Related Link: Report (PDF)

Keywords: Europe, EU, Banking, Climate Change Risk, Basel, Regulatory Capital, Low Carbon Economy, Carbon Tax, ESG, ESRB