Regulation and climate change – what do firms need to know?

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In late October the FCA, PRA, Pensions Regulator and the Financial Reporting Council released a joint statement on the publication of their climate change adaptation reports. Each regulator was asked by the UK Government to produce a report setting out how climate change affects their responsibilities and what actions regulators and businesses are taking in response.

The statement iterates the regulators’ joint commitment to identifying and managing the risks and opportunities presented by climate change and the transition to a net zero economy. In addition, the FCA has now published ‘A Strategy for Change: Our ESG Priorities’, which summarises its Environmental, Social and Governance (“ESG”) commitments, setting out the regulator’s strategy and actions on implementation of ESG commitments and climate change goals for the financial services sector.

The FCA’s climate change adaptation report states its intention to take a lead policymaking role on climate change, sustainability and good governance, emphasising its role in facilitating the transition to a net zero economy by 2050. It also emphasises the importance of ESG concerns, which it sees as a key aspect of the FCA’s agenda going forward. It hopes to embed ESG considerations across all its functions and to encourage the firms it regulates in directing the flow of capital for climate adaptation and the transition to a net zero economy. The FCA says it will do this by demonstrating adaptation and mitigation measures in its own strategy, for a holistic approach to tackling climate change.

The report highlights the main financial risks relating to climate change. These are:

  • Insurance underwriting risk e.g. extreme weather conditions.
  • Credit risk: financial loss due to the deterioration of counterparties’ creditworthiness from the impact of climate change on operations and assets. For example, breakdown of supply chains due to weather events and assets becoming stranded (i.e. becoming worthless or uninsurable due to their exposure to climate change risks) may be underlying causes of increased credit risk to lenders.
  • Financial market risk: the impact on the value of bonds, loans, property/real estate, commodities and equities due to the societal, legal and technological response to climate change. There is evidence that climate risks are not yet accurately reflected within asset valuations.
  • Operational risk: The potential economic, reputational and compliance impacts of inadequate or failed internal processes and systems, or from external events, including legal risk and the risk of a material misstatement in financial reporting.

It also details how different sectors within the financial services markets are dealing with specific harms that are impacting their area more widely and how they are making changes and adapting as a result. It gives details of the pensions, retail investments and lending, wholesale markets and general insurance underwriting.

The FCA states it will oversee the way firms design, deliver and disclose on sustainable finance products, which will include challenging firms on how well their products match their claims on sustainability and oversee compliance with regulatory requirements related to sustainable finance. The FCA will want firms to be able to explain how they communicate with their customers on the sustainability credentials of their products – to help build trust in the sustainable finance market. It also pledges to talk to firms about how they are:

  • managing climate change risks and opportunities and the transition to a net zero economy.
  • integrating these requirements into their culture.

Where firms make claims on net zero targets or moving to a more sustainable finance model, the FCA wants to understand how firms will achieve the goals and commitments they have set for themselves. If firms advertise ambitious targets, the FCA will expect to see that there are realistic plans in place to meet those targets and will want to prevent situations where firms are making unrealistic promises in the name of climate change, with the intention of luring customers with their ESG credentials.

So what does this mean for firms?

The reports and the joint statement from regulators confirm that climate change and the transition to a net zero economy are firmly on the regulatory agenda. Firms can expect to meet with challenge and scrutiny over sustainability credentials and climate change pledges. The FCA and other regulators have set out their objectives to push firms towards a more sustainable business future; businesses should be ready to demonstrate their ESG principles and the steps they are taking to support a more sustainable economy.