28: After Clause 5, insert the following new Clause—
“Considerations in setting capital adequacy requirements
In setting the capital adequacy requirements of a credit institution, the Prudential Regulation Authority shall have regard to—(a) the level of exposure of an institution to climate-related financial risk;(b) the level of compliance of the institution with the recommendations of the Task Force on Climate-Related Financial Disclosure; and(c) the objectives of the Climate Change Act 2008 as amended by the Climate Change Act 2008 (2050 Target Amendment) Order 2019 (S.I. 2019/1056).”Member’s explanatory statement
The purpose of this amendment is to place a requirement on the PRA in setting capital adequacy requirements of a credit institution to have regard to its exposure to climate-related financial risk.
My Lords, I declare my interests as the chair of the advisory board of Weber Shandwick UK, as set out in the register. In moving Amendment 28 in my name and those of my noble friend Lady Kramer and the noble Baroness, Lady Bennett of Manor Castle, I will speak also to the other amendments in this group. I once again express my thanks, in particular to Finance Watch, Positive Money and Carbon Tracker for their helpful briefing, and indeed to all organisations that have taken the trouble to provide me with information on this subject.
The context of our discussion of these amendments is one in which, at current levels of carbon emissions, the world will have exhausted within 10 to 15 years the carbon budget it must stick to if we are to meet the Paris objective of keeping warming well below 2 degrees. This is not the alarmist prediction of some fringe organisation or, indeed, even of a Liberal Democrat politician; it is the sober warning of experts in the field, including the United Nations special envoy for climate action and finance and former Governor of the Bank of England, Mark Carney, who spoke in his Reith Lecture at the end of last year of the struggle between urgency and complacency in tackling climate change, highlighting the contrast between the
“urgency of carbon budgets that could be consumed within a decade and the complacency of continuing to add new committed carbon … The urgency to reorient the financial system for the massive investment needed to create a sustainable economy, yet the complacency of many in finance”.
Mr Carney went on to warn that the tensions that exist in our desire to tackle climate change reflect the common challenge of values, including human frailties and market failures. Nowhere could market failures be more evident than in the failure to price climate risk appropriately within the financial system. That is what the amendments we are debating are all about. In the previous group of amendments related to climate, which we discussed last week, we talked about the purpose of prudential regulation, which is surely to manage and control risk. We spoke also about the fact that our system of prudential regulation is clearly not performing that function in respect of the greatest risk facing the financial system and, indeed, the planet as a whole: climate change.
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That means, first, that we need regulators to price-risk effectively in order that the financial services industry approaches investments in these industries adequately accounting for the fact that many assets will inevitably become partially or wholly stranded. Secondly, but just as importantly, the Government need to step up now and engage in transition planning with the industry with a much greater degree of urgency than has been evident to date, so that communities currently dependent on fossil fuels can transition to new green industries and avoid the fate of the former mining communities.
What we cannot do is either pretend that this transition is not going to have to happen or fail to prepare adequately for when it does. It is the inevitable outcome of achieving net zero and averting climate disaster. The only thing that denial will achieve is to make the transition harder than it needs to be and to pile a financial crisis on top of a climate crisis.
As Mark Carney said in the Reith lecture that I alluded to earlier:
“To stabilise temperature rises at any level, we must reach net zero, where the amount of carbon emitted and the amount taken out of the atmosphere, are equal. So it’s important to recognise that net zero isn’t a slogan, it’s an imperative of climate physics.”
It is an imperative that the Government and the financial services regulators must accept and start acting on. The consequences for the climate and for the viability of the financial system if they fail to do so do not bear thinking about.
I hope that in his response the Minister will address himself directly to, first, the role that the Government see risk weighting and capital adequacy requirements playing in mitigating the micro and macro prudential risks of fossil fuel investments. Secondly, I hope that the Minister will tell us how the Government plan to up their game, so that we have in place a comprehensive transition plan from the fossil fuel industries of today to the green jobs of tomorrow. That second part will be critical in ensuring that we learn from the wrong done to former mining communities and that, this time, we make sure that stranded assets do not lead to stranded and abandoned communities. I beg to move.
My Lords, it is a pleasure to take part in day three of our Committee deliberations on the Financial Services Bill. In doing so, I declare my interests as set out in the register. I will speak to Amendment 136A in my name, concerning environmental, social and governance—ESG—factors.
The rationale behind my amendment is quite simple: what is the point of profit if there is no planet to spend it on? In this amendment I am seeking to look at the funds’ billions of pounds of assets, under fund managers. It would probably be helpful for institutional investors and individuals to know a lot more about those funds and where their assets are invested. It is a very simple amendment, requiring the Secretary of State to make regulations to have fund managers report on how their funds—and, indeed, all the constituent parts of their funds—stack up against agreed ESG considerations.
The reason I stated it like that in the amendment is so that there can, I hope, be a public discourse around what all parties believe should be measurable and helpful when considering the operations and activities of these funds. The SDGs are obviously important—there is a reasonable level of global agreement around them—but there are other factors specifically relevant to certain sectors or regions of the UK. There could be a public debate, whereby the Secretary of State could consider what would form the particularities of the ESG for fund managers to report on.
I do not believe that the amendment would in any way fetter the market or overstep into the market—it certainly does not seek to—and nor does it seek to direct funds in one particular direction or another. What I hope it would do is throw light on the funds to enable far greater clarity of decision-making by investors, institutional or individual, into those funds. It is in no sense seeking to control or direct activity.
My Lords, most of the amendments in this group are about bank capital. I believe strongly that the setting of the capital requirements of individual banks should be about prudential risk to the capital of the banks and the resilience of the financial system as whole. The setting of bank capital should not get caught up in wider policy issues.
On Amendment 28, the level of exposure to climate-related financial risk should indirectly already be taken into account in the conventional capital-setting process. Climate-related financial risk is very unlikely to be a separate risk category for a bank. It is primarily a credit risk—the risk that borrowers will not repay loans—and it does not need to be separately considered. There may need to be adjustments made to banks’ evaluation of how credit risk will crystallise due to climate change but the essential elements—calculating the exposure at default and the loss that would arise if default occurred—are already in the system.
The impact of climate change on banks is very much an emerging area. I am sure noble Lords will have heard of the so-called biennial exploratory stress test, which the major banks need to submit to the Bank of England later this year. It will focus on how these risks will evolve under various scenarios, which have not yet been published by the Bank of England.
It is pretty unlikely that climate-related financial risk would have a major impact on current bank capital because the determination of bank capital contains buffers which are derived from stress tests that focus on the next five years. Therefore, the impact of risks from climate change working their way through credit risk is unlikely to find its way into bank capital in the short term. That is why the Bank of England’s exploratory stress test seeks to understand how this will evolve over a longer period. In addition to credit risk, there may be an element of operational risk, but that too should be capable of being captured by the existing rules for the calculation of operational risk.
My Lords, it is always fascinating to follow the noble Baroness, Lady Noakes. I certainly do not have her level of expertise in financial institutions but, listening to her, I worried that the phrase that the noble Lord, Lord Oates, used about the battle between urgency and complacency was actually rather relevant. We have a very short period of time in which to change the dynamics of what is happening to our world through climate change. I am sure that these amendments could be better drafted, and we may need her technical knowledge and experience to help us find the correct levers to do what Amendments 28, 31 and 32 set out to do, but, frankly, we cannot afford simply to say that this will not work. We have to find ways that will work, which is why I am interested in, and listened carefully to, the powerful and compelling case made by the noble Lord, Lord Oates, in introducing these amendments.
We have to find a way in which to make explicit and transparent the risks contained in continuing investment in existing fossil fuel projects or new ones, and that funding new fossil fuel projects is essentially of the highest risk and should be funded out of equity if it is to go ahead. The risks relate not only to continuing investment contributing to climate change, which itself creates systemic risk through increasing emissions, but to the certainty of these assets becoming stranded, as the noble Lord, Lord Oates, said. That is not in the long term—we are talking about the reasonably predictable future.
A recent report by Finance Watch, Breaking the Climate-finance Doom Loop, highlighted that to limit warming to 1.5 degrees we can emit only a further 500 gigatonnes of CO2. There are currently fossil fuel reserves which, if all were extracted, would emit 3,000 gigatonnes. If we are to have any hope to meet what are not just the aspirations of what the noble Baroness calls the “green lobby” but are actually our national and international treaty obligations, we have to change. Despite the fine words that have been spoken since Paris, $2.7 trillion in funding has been provided since that agreement to the oil and gas industry, with UK banks contributing significantly.
My Lords, I refer to my interests in the register. It is a pleasure to follow the noble Baroness, Lady Hayman, and my noble friend Lady Noakes, who spoke eloquently on the capital requirements. I was planning to do the same, but she has said much of what I was planning to say, so I shall confine myself to a brief question about Amendment 31.
Amendment 31 refers to
“existing fossil fuel production and exploitation.”
I wonder whether all the possible consequences have been considered. The noble Lord, Lord Oates, spoke eloquently on mining, and I, too, claim mining ancestors: my great-grandfather was a coal miner in Seaton Burn in Northumberland. The noble Lord also mentioned stranded and abandoned communities. I wonder whether the amendment, as drafted, would also apply to companies that are actively engaged in the complex process of decommissioning existing facilities, particularly those in the North Sea. In many cases, those are the same companies that are involved in exploitation and exploration. Again, my noble friend Lady Noakes spoke very eloquently about hypothecation when it comes to lending to some of these types of companies. With that in mind, were the potential regional effects of rationing capital to these businesses considered, because that is the likely net effect of the amendments? I suppose that that would have particular reference to and relevance in Scotland.
I am sure we all hope for a world free from fossil fuels, but I am 100% confident that, regrettably, we will need them for a while yet—although it is probably worth stating that they have other uses apart from just being burned. As my noble friend Lady Noakes also pointed out, it is fair to say that financial institutions have a refined—no pun intended—approach to assessing fossil fuel-related risk and are perfectly capable of valuing stranded assets. The proof of that is to be found in the valuation of companies such as BP and Royal Dutch. If, as the amendments imply, we would prefer no lending at all to fossil fuel companies—which is a perfectly legitimate point of view—should we not just say that and agitate for a multinational agreement to that effect, perhaps at COP 26, rather than introduce it via the back door through amendments such as these?
My Lords, I am not a financial expert, nor was that my academic background, nor do I have family involved in the fossil fuel industry, because Northern Ireland did not have a mining base. However, it is quite clear to me that the Financial Services Bill is silent on the climate emergency and carbon issues. Therefore, I favour the amendments in this group in the names of the noble Lord, Lord Oates, and other colleagues.
A recent Bank of England publication states:
“Climate change poses different risks to the stability of the financial system, particularly for the insurance and banking sectors.”
It states that there are physical, transition and liability risks from climate change. Climate change means that we may face more frequent or severe weather events, such as flooding, droughts and storms. Examples of those recent weather events that have been linked to human-driven climate change include the heatwave and droughts in China in the summer of 2013 and the more recent flood events in the UK. Such events bring physical risks that impact on our society and have the potential to affect the economy, and our financial services sector. If these events happen more frequently, people will become more reliant on insurance to cover the costs of damage to their houses and cars.
Transition risks can occur when moving towards a less polluting, greener economy. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business. One example is energy companies. If government policies were to change in line with the Paris Agreement, two-thirds of the world’s known fossil fuel reserves could not be burned. This could lead to changes in the value of investments held by banks and insurance companies in sectors such as coal, oil and gas.
Liability risks come from people or businesses seeking compensation for losses that they may have suffered from the physical or transition risks from climate change.
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Amendment 28 seeks to take the first steps in addressing this issue. It requires the Prudential Regulation Authority, in setting capital adequacy regulations, to have regard to climate issues, including the level of exposure of an institution to climate-related financial risk and the level of compliance of that institution with the recommendations of the task force on climate-related disclosure and the net-zero objective of the Climate Change Act, as amended.
Amendment 42 requires the Treasury to amend the credit rating agencies regulations to require such ratings to explicitly take account of the level of exposure of an institution to climate-related financial risk.
Both amendments aim to act as a wake-up call to regulators and the City so that, when setting capital adequacy requirements and issuing credit ratings, they take account of and act on the risks that climate change poses to individual institutions and the financial system as a whole.
Amendments 31 and 32 in my name and those of my noble friend Lady Kramer and the noble Baroness, Lady Altmann, focus specifically on fossil fuel exploration, exploitation and production. I am particularly grateful to Finance Watch for its advice and recommendations in this regard. Amendment 31 sets out the risk weight the PRA must apply to the funding of existing fossil fuel production and exploitation; Amendment 32 does the same in respect of new fossil fuel exploration, production and exploitation. They both seek to do so within the existing framework of the Capital Requirements Regulation, which sets capital requirements on a risk-based approach.
The two amendments apply different risk weights to the different activities addressed in each because the financial risks associated with the two activities are different: exploiting existing reserves runs a high risk that some fossil fuel assets will become stranded during their lifetime, whereas exploring and exploiting new reserves comes with a much higher risk—indeed, a near certainty—that they will become entirely stranded.
Amendment 31, dealing with the risk weighting for existing fossil fuel investment, is tailored around Article 128 of CRR as amended in CRR2. This deals with what it describes as:
“Items associated with particular high risk”.
Paragraph 1 of Article 128 states:
“Institutions shall assign a 150% risk weight to exposures … that are associated with particularly high risks”
and that for the purposes of the article, institutions should treat any of the following as exposures with particularly high risks:
“investments in venture capital firms, except where those investments are treated in accordance with Article 132 … investments in private equity, except where those investments are treated in accordance with Article 132 … speculative immovable property financing.”
Paragraph 3 of Article 128 goes on to state:
“When assessing whether an exposure … is associated with particularly high risks, institutions shall take into account the following risk characteristics: (a) there is a high risk of loss as a result of a default of the obligor; (b) it is impossible to assess adequately whether the exposure falls under point (a).”
As Finance Watch points out in its excellent report Breaking the Climate-Finance Doom Loop, paragraph 3 of Article 128 almost appears to have been written specifically to deal with stranded fossil fuel assets: first, because, if we manage to meet net-zero targets, a large proportion of existing reserves will have to remain in the ground, leading to the probability of default of the obligor, the issue addressed in Article 128(3)(a); and, secondly, because assessing the scale of the stranded asset risk is impossible given that it relates to a unique situation for which we have no historical precedent but in which we know that the future economic performance of the assets must be downward—the situation exactly envisaged and provided for in Article 128(3)(b).
Accordingly, Amendment 31 would apply an approach consistent with Article 128 of the CRR to make it explicit that the PRA must apply the 150% high risk weight in calculating capital requirements for existing fossil fuel funding. This risk weight is already applied to venture capital firms, private equity and speculative immovable property, and it is hard to understand how fossil fuel operations can be regarded as posing less risk. The fact is that the existing 100% risk weight is an incentive to the financial markets to continue to act as if nothing has changed. A 150% risk weight, by contrast, would provide a clear price signal reflecting the risk to assets but would not prevent the continued financing of existing fossil fuel operations, allowing an orderly and just transition for those industries and the communities that rely on them.
Amendment 32 addresses the much bigger threat to the climate and to the financial system that arises from new fossil fuel exploration, production and exploitation. It would require such investments to be funded entirely by capital by applying a 1,250% risk weight to this activity. This risk weight is calculated with reference to Article 92 of the CRR on own funds requirements, which obliges institutions to maintain at all times a total capital ratio of 8%. This provides the basis to determine the risk weighting to apply to ensure that new fossil fuel activities are funded entirely from equity.
The 8% total capital requirement is multiplied by the risk weight of 1,250% in accordance with the standardised approach, resulting in a 100% capital requirement for these activities. This risk weight is not some wild or punitive sanction; it is the considered application of the real risk such investments pose to the institutions themselves, to the financial system as a whole and to our ability to stabilise the temperature of the planet. It is also consistent with the existing risk weight applied under the capital requirements regulation for holding companies, as defined in Article 89.
Requiring any fossil fuel investment to be entirely equity funded is surely appropriate, given that these activities will either become non-viable because we have succeeded in stabilising the climate by reaching our net zero targets, or, if we have not, they will be fuelling runaway climate change which will threaten the viability of the whole financial system, not to mention our entire way of life.
The truth is that we have no chance of meeting the objective of the Paris Agreement to keep warming to well below 2 degrees, and ideally to 1.5 degrees, if we burn all the carbon in existing reserves, let alone exploit new ones. The regulatory system has to take account of that, and it has to adequately price risk for those institutions that wish to invest in activities which must become non-viable if we are to prevent catastrophic climate change. In doing so, it will help ensure an orderly and just transition away from fossil fuels.
I want to be very clear that these amendments are not driven by any animus against the fossil fuel industries, whose products have been critical to the development of human society, whether by keeping us warm or driving industry and prosperity. Indeed, my own title in this place is taken from Denby Grange colliery, where my uncles and my grandfather were miners, engaged in the critical but dangerous job of mining the fuel that provided heat and power for the nation.
As we know, coal mining as a major industry in the UK came to an abrupt end in the 1990s. The way it did so, driven by political malice and with no transition planning at all, devastated the mining communities which had fuelled the country’s prosperity over a period of more than 200 years. Abandoned by government, these communities were beset by huge economic and social problems, many of which exist to this day. We cannot allow that to happen in the oil and gas industry.
I hope the Minister will accept the amendment in the spirit in which it is being offered. It would aid a greater debate and understanding of funds and their operations. In some small way, it would indicate how we can move forward and have real-time analysis of these funds’ investments using many of the new technologies available to us, not least distributed ledger technology and elements of artificial intelligence, which can instantly adopt, analyse and report on the ESG performance of any fund and constituent part of it. The power that these new technologies affords us would not have been available three or five years ago, never mind a decade ago.
I ask my noble friend the Minister to consider both the positive impact that such a requirement could have and the deployment of new technologies to achieve the objectives set out in Amendment 136A.
These points are also relevant to Amendment 42, which tries to get climate-related financial risk into credit ratings. I am sure that the credit rating agencies need no reminders about any kind of risk and I would expect the biennial exploratory stress test to be an important input to their thinking on how their ratings will evolve. But, again, this will be over time and not something that is done immediately.
Amendment 28 seeks to ensure that disclosure requirements are also taken account of in setting bank capital. It would be wholly inappropriate to include compliance with disclosure requirements in the calculation of bank capital requirements because disclosure can never have an impact on the amount of capital that a bank needs to keep. It is an extraneous consideration that should not feature in the determination of prudential capital. I have absolutely no idea on what rational basis capital requirements for individual banks could be adjusted for the climate change objectives of the Government, which also features in Amendment 28.
As the noble Lord, Lord Oates, has explained, Amendments 31 and 32 would require mandatory risk weights for exposures related to fossil fuel; namely, 150% for existing exposures and 1,250% for new funding. These are both penal and unrelated to the underlying credit risk. I accept that funding fossil fuel exploration might well carry higher risks in the future than it does currently, but that will be reflected in banks’ evolving lending policies, including pricing for risk, and in the risks that are reflected in how they calculate credit risk-weighted assets.
Risk weighting is about loss at default and these amendments are suggesting that there could be a total loss at default; that is the particular implication of the 1,250% risk weight for new exploration. Neither assumption is realistic. Banks do not lend in situations where default is likely or total losses will occur, and I did not understand the reference to 100% equity funding in the explanatory statement: banks lend money; they do not make equity investments in the companies with which they deal.
In general, corporate borrowing is not linked to specific activities. At the weekend, when I was at home thinking about what I was going to say on these amendments, I found a copy of Shell’s most recent accounts, which I looked at to see how its balance sheet was made up. Most of Shell’s debt is in generic corporate bonds, rather than for specific activities within Shell. Like other major oil and gas companies, Shell has a mix of activities, including those which the green lobby will approve of.
As drafted, by reference to
“exposures associated with the funding of existing fossil fuel production and exploitation”,
the amendments are probably ineffective because lending is not likely to be hypothecated in the way the amendments assume. I should also say that Shell, as a corporate borrower, currently has long-term credit ratings of A+ and Aa2, which imply a low risk of default and therefore a relatively low likelihood of loss needing to be taken account of in the way that assets are risk weighted.
Even if these amendments were drafted in a way that was effective and made sense, I suspect that the only real-world impact would be that debt financing for oil and gas companies would be driven out of the London market. Why on earth would we want to deprive the City of London of relatively low-risk, profitable business?
Financial institutions are in the process of quantifying climate-related financial risks, but it is widely recognised that this will take considerable time. Rather than waiting until the middle of the decade when we have made progress in quantifying the risks via the TCFD and climate-related financial risk disclosures, we could start to make changes to the existing capital requirements regulation now, to reflect what we all know are risky investments, even if we do not know the exact quantified risk. Prudential regulations are designed for just such a situation, to regulate markets and ensure long-term stability.
We have to make it very clear what the risks are, because there is danger of interpretation of risk from the transition from brown to green being considered in the light of it being a sudden cut-off of one and a change to the other, so that people avoid any change. We need a measured and adjusted transition. To do that, we need to be aware of risks on all levels.
Finally, I will say a word or two on taxonomy: how we actually define green and brown. In previous Committee debates, the noble Earl the Minister said
“we need to be able to define what we mean by ‘green’.”—[Official Report, 24/2/21; col. GC 225.]
He commented that it will take time to analyse the risks and produce the taxonomy. It is important that we recognise that that taxonomy needs to include a definition of what is a brown asset as well as what is green. We need to look at how we drive investment away from brown, as well as directing it to green.
The New Economics Foundation recently wrote to the Chancellor, saying that
“limiting the taxonomy to green activities will not necessarily encourage a move away from financing activities that undermine climate goals. We equally need the taxonomy to classify carbon-intensive and other unsustainable activities. Importantly, the taxonomy design should not be decided behind closed doors. There must be transparency and public consultation to ensure that a wide range of expertise and perspectives from across civil society and academia feed into the UK’s Green Technical Advisory Group.”
It would be very good to understand government thinking on this issue and on the timing of the work of the green technical advisory group, and I hope that the noble Earl will comment on this when he winds up or, if that is not possible, write to me in the future.
It is important to tackle climate change and protect the environment. This is very important in the financial services sector; I think the Chancellor of the Exchequer referred to that in the recent past. As I said, there is no reference in the Bill to climate or the ecological emergency, notwithstanding that the UK Government have the chair of COP 26 this year. There is no mention of green finance, climate risk disclosure or the critical role that the financial services industry will have to play if we are to tackle climate change.
How do the Government intend to deal with this matter from a legislative point of view? It is recognised as a clear priority by the Chancellor, although the Minister who took the Bill through the other place did not see any direct correlation between financial services regulation and the impact and risk of climate change. Parliament should determine that role and ensure that these amendments are made to this legislation. The amendments, which I support, would require the Prudential Regulation Authority to have regard to climate-related financial risk when setting capital adequacy requirements, and would ensure that credit rating agencies have to take climate risk into account in setting credit ratings, with particular relevance to fossil fuel exposures. I think of the fact that the Government wish to pursue a new coal mine in Cumbria.
Do the Government not see the benefit in these amendments to have regard to climate-related financial risk when setting capital adequacy requirements? If not, could they specify what their position is? Will they not admit that there is a direct correlation between the climate change emergency, fossil fuels and financial services regulation? Perhaps the noble Earl could provide us with answers when he winds up.