Frontloading ESG risks and benefits into the capital charge to incentivise green financing

Abstract

Climate-related physical and transition risks are at the top of the financial regulators, supervisors and the financial institutions' (FI) agendas. The financial regulators/supervisors' objective is to keep the system safe and sound during the transition to a greener economy. The key initiatives include incorporation of climate-related risk into risk and capital management frameworks and the related Pillar III Financial Disclosures. Macroprudential stress tests to investigate how climate-related risks propagate through the real economy and the financial system have been, and are being, published. This paper examines these initiatives and challenges and makes the argument that while these initiatives are necessary, they are not sufficient. A systemic solution is needed. The expected transition to a lower-carbon economy is estimated to require around US$1tn in investments each year for the foreseeable future. This makes the role of the financial sector during the transition imperative. The paper argues that the policy objective should be not only that the financial system simply remains resilient during the transition, but that it also helps facilitate the transition. This facilitation must be on an equal playing field for FIs and should emerge as the natural outcome of their profit maximising behaviour in a competitive marketplace. A solution is proposed to do so. It effectively frontloads the longer term environmental, social and governance (ESG) risks and benefits into the current capital and, thus, pricing and profitability frameworks. Numerical examples are provided to explain.