Regulators are bolstering their work on transition planning and nature as they look to support the transition to net zero, Annabelle Palmer reports
After a recent webinar on what central banks, financial regulators, and other relevant stakeholders can do to deliver net-zero and nature-positive outcomes, Environmental Finance selected audience questions to pose to webinar speakers Goh Gek Choo from the Monetary Authority of Singapore (MAS) and Maud Abdelli and Siti Kholifatul Rizkiah from WWF.
The webinar, 'Navigating the green shift: overcoming challenges in climate and nature transition finance' was run in partnership with WWF and discussed the findings of WWF's 2023 Sustainable Financial Regulations and Central Bank Activities (SUSREG) Tracker.
WWF evaluated progress on the integration of environmental and social risks into central banking, financial regulation and supervision activities in 47 countries which together represent over 88% of global GDP, 72% of global GHG emissions and 11 of the 17 most biodiversity-rich countries in the world.
While notable progress has been made, serious gaps remain, and progress is uneven, WWF found.
You can watch the webinar on demand here.
Key takeaways from the webinar include:
- Countries have made strides in enhancing their banking and insurance supervision. In 2021, the average SUSREG fulfilment of climate banking supervision was 33%, and it has now increased to 45% in 2023. Similarly, insurance supervision taking into account climate risk has shown progress, with a fulfilment increase from 27% in 2022 (where the assessment started) to 37% in 2023.
- However, progress varies among countries, and significant gaps persist. In 20 countries with net-zero targets covered by SUSREG, weak climate financial supervision is evident. Moreover, supervision concerning nature risks is notably negligent compared with climate risks.
- Due to a number of reasons. Unlike climate change, nature risks lack a single measurement metric, and their site-specific nature leads to unevenly distributed impacts, prompting diverse responses and data challenges.
- Financial regulators address climate change and nature loss through the lens of financial risks and would require robust models and data to credibly quantify these risks. A precautionary financial policy mindset acknowledges the importance of measuring risks while emphasising preventive action in the face of uncertain and potentially catastrophic environmental threats. This entails using available micro and macro-prudential supervision tools to enhance resilience of the financial sector to environmental risk, while continuing to work on improving existing data and methodologies.
The responses to a selection of audience questions are below.
Question: If a central bank/supervisor concludes that their market is misaligned with global climate and nature goals, what can they do – especially to disincentivise negative economic activities?
Siti Kholifatul Rizkiah: There are many ways in which a central bank/financial supervisor can take action to disincentivise capital flowing to harmful economic activities.
Firstly, they should publish their own transition plan that covers a strategy and implementation plan for the whole financial sector to achieve climate and nature targets.
Next, they can utilise several supervisory tools such as charging higher capital for lending to high emitting and harmful sectors, setting exposure and concentration limits to these harmful sectors, as well as requiring financial institutions to put in place internal climate and nature targets with periodic monitoring. This would require them to adjust their portfolio accordingly and disclose their transition plan on how financial institutions can adjust any misalignment.
Lastly, central banks and financial supervisors should also periodically monitor the alignment of their supervised entities with the Paris agreement and Kunming-Montreal Global Biodiversity goals and conduct the necessary corrective actions including guidance, penalties, or changes in their strategies to ensure compliance with global sustainability goals.
Q: For financial institutions, transition planning relies on transparent disclosure of their impact, dependencies, and transition plans from real economy corporates. Financial institutions also need a framework to assess the credibility of a corporates' transition plan. Do you think these statements are true? Is there a gap in these two areas? If so, without transparent information from corporates and without an assessment framework, how would you advise the financial institutions conduct their transition planning?
Gek Choo: Last year, MAS issued a consultation on a set of guidelines on transition planning. In the consultation, we have defined transition planning as the internal strategic planning and risk management processes undertaken to prepare for both risks and potential changes in business models associated with the transition.
Our focus on transition planning stems from our interest to see financial institutions walk the talk, and to establish processes to engender sound business decisions and risk management practices. Under the proposed guidelines, we set out three key expectations: Engage, Explain and Encompass.
- Engage, and not divest: Financial institutions should engage and enable their customers and investee companies to transition in an orderly manner. Divesting should not be the first option because this hinders companies with credible transition and adaptation plans from securing the financing they need to make the transition. Through such engagement of their real economy customers, a financial institution would also have the opportunity to collect additional information that is needed for its transition planning.
- Explain, to be accountable to stakeholders: From time to time, supporting transitioning customers or investee companies may result in higher interim carbon emissions. A real gap may also arise between planned and actual emissions when targets are missed. These should not deter financial institutions from facilitating the needed transition of the real economy. But when a gap happens, financial institutions should provide clear disclosures and explanations to help correct any market misperceptions that they have departed from their stated risk appetites or commitments. Financial institutions should also share the steps they are taking in response.
We have seen some financial institutions using science-based pathways as the reference scenario for setting emissions targets and engaging their customers, such as the IEA Net Zero Roadmap. However, sectoral pathways that are global in scope may not apply well to every region. Financial institutions operating in emerging markets such as in Asia can benefit from more contextualised pathways, especially for sectors such as power generation where the nature and pace of transition will differ markedly across regions and countries.
- Encompass all risks: In addition to climate risk, financial institutions have to address nature-related risks as an interconnected risk. There can be important inter-dependencies between climate and nature as well as the potential trade-offs such as environmental degradation arising from pursuing climate solutions. Financial institutions need to start to factor nature-related risk considerations sooner rather than later.
Maud Abdelli: There is a lack of a clear framework for evaluating corporate climate transition plans. This lack opens a window for greenwashing, where companies may commit to vague and difficult-to-assess targets. To address this, regulators should establish a comprehensive framework for formulating and evaluating credible transition plans, specifying the necessary statements and commitments while indicating what should be avoided.
Various frameworks, such as the Climate Bonds Initiative (CBI) (e.g, 1.5-degree aligned, front-loaded, no offsets), have been issued to guide the development of credible transition plans.
Some supervisors, like the Australian Securities and Investments Commission (ASIC), have already engaged directly with corporates and financial institutions to rectify inconsistencies in transition plans, as ASIC's report on regulatory interventions related to net-zero statements and targets indicates.
The WWF has also contributed by publishing red flag indicators to assess greenwashing and inconsistency in transition plans, highlighting the essential elements such as absolute emission reduction targets, interim metrics, avoidance of interim target reliance on offsets and carbon credits, annual greenhouse gas (GHG) inventory, and an immediate strategy for fossil fuel phase-out.
Financial institutions can start conducting their transition planning by following these frameworks alongside clear objectives and measurable intermediate and long-term targets, integrating climate considerations into decision-making processes and conducting scenario analyses to assess portfolio resilience.
Q: What potential do you think greening collateral frameworks have as a signalling tool for banks and non-FI's?
Siti Kholifatul Rizkiah: The collateral framework is vital in the financial system. It influences how commercial banks access central bank liquidity and impacts credit conditions for non-financial corporations. However, current frameworks favour financing carbon-intensive activities. Greening the collateral framework may involve two approaches: adjusting credit assessments in the collateral framework to capture climate-related financial risks and modifying haircuts and the eligibility of assets based on the environmental impacts of financial assets.
The use of "brown" collateral haircuts, which may involve higher costs or reduced eligibility for environmentally harmful assets, discourages investments in carbon-intensive or environmentally damaging activities. Conversely, "green hairgrowth" measures, such as reduced costs or enhanced eligibility for environmentally friendly assets, encourage and incentivise investments in green and sustainable initiatives.
There should also be collateral concentration limits for assets coming from always environmentally harmful activities, as listed in the WWF Central Banking and Financial Supervision Roadmap (p.34-40).
Q: Should divestment in carbon intensive sectors be a goal? Or do you see problems with this kind of target?
Gek Choo: Supervisors are not in the position to say how green or not green a bank's portfolio is. However, it is important to note that indiscriminate divestment by climate-conscious financial institutions from carbon-intensive sectors may lead to unintended consequences like stranded assets or movement to financial institutions without such policies in place.
This may result in higher risks to the system in the longer run, such as from a disorderly transition scenario. It is more helpful for a financial institution to engage and help real economy customers in developing or enhancing their own plans to address climate-related risks, which can then align with the financial institution's risk appetite, commitments and ambitions.
Maud Abdelli: The initial course of action should be to engage with clients to influence their business operations and facilitate the transition to greener practices, including phasing out of carbon-intensive activities. This involves providing essential support, including financial products and technical assistance, to facilitate a smooth transition.
However, if necessary, divestment from carbon-intensive sectors can be considered a final option for institutions seeking to align their portfolios with environmental sustainability. This strategy fits with various climate scenarios (e.g. IEA scenarios) that require the phasing out of fossil fuels to achieve climate goals (i.e. net zero by 2050).
It also serves to mitigate financial risks linked to stranded assets and potential devaluation of carbon-intensive holdings during the global shift to a low-carbon economy. Moreover, divestment communicates a powerful message to clients, investors, and the public, signalling a lack of financial resilience in supporting carbon-intensive sectors.
But it should not solely rest on financial institutions. It is imperative for the government to demonstrate a strong commitment to phasing out carbon-intensive energy. This commitment can be substantiated by providing tangible incentives for adopting greener energy sources and implementing disincentives for carbon-emitting activities (e.g. carbon tax and other measures).
Q: The 'social' indicators are lagging by quite a large margin versus 'climate' and others. Why is this, and how can central banks play a role in improving this?
Siti Kholifatul Rizkiah: Governments and regulatory bodies have been placing a stronger emphasis on climate and environmental risk, leading to a lower level of perceived urgency for social risks.
Social risks often involve a wide range of interconnected and complex factors, such as human rights, labour practices, inequality, community impacts, and financial inclusion which are inherently challenging to quantify and measure accurately. Unlike environmental data, social data lacks standardised reporting frameworks which makes it difficult for financial institutions to compare and analyse social performance across different companies and industries.
But financial institutions can start working on social issues by integrating social criteria into credit risk assessments, policies and decision-making processes, and due diligence procedures. They can actively encourage their clients to disclose relevant social performance data through engagement, partnerships, and by incorporating disclosure requirements into lending agreements.
Financial institutions can also promote financial inclusion by providing access to banking services for underserved populations, supporting microfinance initiatives, and fostering economic empowerment in communities.
Central bank and financial supervisors should also take part in fostering this as the responsibility does not lie solely on financial institutions.
Goh Gek Choo is executive director of the Banking Department II at MAS. Maud Abdelli is lead for the Greening Financial Regulation Initiative at WWF and Siti Kholifatul Rizkiah is lead for Sustainable Financial Regulations and Central Bank Activities (SUSREG) at WWF.
Environmental Finance has also written the following two stories on the webinar:
- Regulators need twin focus on nature and climate risks, says WWF
- Nature scenarios are 'one of the most complex tasks' facing supervisors