Regulating to support Net Zero, Part 2: Climate Change Adaptation Reports

By Rachel Waggott, Head of Regulatory Affairs, Innovate Finance

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This is the second in a series of blog posts on the UK regulators’ approach to climate change. You may also be interested in our White Paper on Net Zero and our coverage of the Government’s Net Zero strategy, here.

As COP26 wraps up, we take a look back at the flurry of documents published over the last fortnight which map out the regulators’ strategic direction of travel. The Climate Change Adaptation Reports - issued on 28 October by the Financial Conduct Authority (‘FCA’), Prudential Regulation Authority (‘PRA’), and The Pensions Regulator (‘TPR’) (with the Financial Reporting Council’s version to follow later this year) - overlap with 2021/22 Business Plans, setting out the regulators’ responsibilities as well as actions that regulators and regulated firms are taking. Coupled with the launch of its refreshed Environmental, Social and Governance Strategy (‘ESG’), the FCA set out one of the more ambitious work plans to support the transition to Net Zero. 

This blog outlines the key points of interest for FinTechs, below. The main headlines at a glance are:

• Climate change is now a significant priority for the  financial regulators. That has some compliance issues for some Fintechs and also huge product implications and opportunities for FinTech and RegTech.
• The financial services regulators have acknowledged the need for a ‘joined up’ approach to climate change to ensure there is a common language and standards for regulated firms. They are also supportive of the International Financial Reporting Standard Foundation’s newly created International Sustainability Standards Board (‘ISSB’), which will issue consistent reporting standards.
• The FCA is utilising innovation tools to support the wider sustainable finance agenda - it highlighted initiatives like the Digital Sandbox Pilot, the second Green FinTech challenge and the Sustainability TechSprint.
• The FCA’s revamped ESG Strategy focuses on the five Ts - transparency, trust, tools, transition and team - and emphasises that climate change is only one pillar of its ESG work programme. The FCA wants to role model behaviours and be recognised as ‘walking the walk’ on all areas ranging from climate change to diversity and inclusion.
• Foreshadowed in the ESG Strategy document, this month saw the launch of the FCA’s highly anticipated Discussion Paper on Sustainability Disclosure Requirements and product labelling (you can read our blog on this Discussion Paper, here). 
• Next month, the FCA will issue its Policy Statement on TCFD-aligned disclosures for a wider set of listed issuers and for asset managers, life insurers and FCA-regulated pension providers.
• From 2022, the PRA will intensify its supervisory scrutiny of firms’ progress against its published expectations on climate change. Where necessary and appropriate, the PRA has signalled that it will consider the use of risk management and governance related capital scalars or capital add-ons, and/or the appointment of Skilled Persons (under s. 166 Financial Services and Markets Act). 
• The PRA is to examine whether amendments are required to the regulatory capital framework in the context of climate change; the regulator intends to publish its approach in Q4 2022.
• TPR’s proposed new code of practice will include several climate-related modules in order to support Trustees in meeting their duties. TPR indicated it will work with the Department of Work and Pensions to share best practice on climate risk reporting.

Financial Conduct Authority: ambitious plans and continued support for innovation

Paying heed to the Chancellor’s remit letter in March, the FCA’s 2021/22 Business plan,  ESG Strategy and Climate Change Adaptation taken together articulate an ambitious work plan to address climate change (and other ESG outcomes) over the short term. The regulator is cognisant that it needs to ‘walk the walk’ in order to credibly hold regulated firms to account on ESG-related matters - to that end, Sacha Sadan, the new ESG Director, has been tasked with embedding ESG across the organisation. Looking outwards, the FCA wants to see increased transparency and trust to counter greenwashing and facilitate a market-led transition to a Net Zero economy - the proposals for new sustainability disclosures and financial product labels go some way to address this. 

Sifting through the Climate Change Adaptation Report and ESG Strategy,  what is important for FinTechs?

Proportionality in rule making and supervision

The FCA signalled that it will tailor its approach to rule making and supervision for small and medium-sized organisations - this proportionality is welcome. The main supervisory focus, the FCA indicated, will be on larger firms in the sectors where there are more likely to be climate-related risks - particularly asset managers and insurers - as well as firms that badge themselves as ‘green’. This broadly translates to the current in-scope firms under the proposed Sustainability Disclosure Requirements, though we anticipate that analogous rules will be introduced more widely across the financial services sector in the coming years.

Support for innovation including regulatory technology (‘RegTech’) and supervisory technology (‘SupTech’)

The FCA continues to support innovative solutions to tackle climate-related issues, and Innovate Finance was on the Advisory Panel of the recent FCA Digital Sandbox Pilot assisting firms at the proof of concept and proof of value stages. 

Nikhil Rathi, FCA’s CEO, commented that regulators - as well as firms - need to adapt and innovate to meet Net Zero targets. The ESG Strategy trailed that the regulator is readying itself for a data-led world and it will take an innovative approach to the supervision of firms on ESG matters. We can see this play out as the October 2021 Sustainability TechSprint was the first to have a SupTech focus. Innovate Finance welcomes this and will continue to encourage the adoption of RegTech, including SupTech. It will also be important for the joint FCA-Bank of England Digital Regulatory Reporting programme’s scope to include disclosures proposed under the UK Sustainability Disclosure Requirements (to the extent they are introduced after the consultation period next year).

Opportunities for FinTechs to solve issues with climate-related scenario analysis in retail lending?

Both the FCA and PRA Climate Change Adaptation Reports flagged up concerns around lenders’ behaviour: though mortgage providers could be seen to capture climate-related risks in credit risk calculations, there was limited evidence of a strategic and organisation-wide approach to climate risks. There may be opportunities for FinTechs to augment major lenders’ climate-related scenario analyses and modelling capabilities to help evaluate whether there ought to be changes in firms’ risk appetite, portfolio composition, disclosures, and broader organisational strategy.

Prudential Regulation Authority: intensifying supervisory scrutiny and examining the regulatory capital framework

Sam Woods’ foreword to the PRA’s Climate Change Adaptation Report underlined that it was the first financial regulator to publish a set of supervisory expectations for banks and insurers on their management of climate-related financial risks, as well as launch a climate-related scenario exercise (the Climate Biennial Exploratory Scenario (‘CBES’)). Climate change will now become a core piece of the regulator’s supervisory work. The two takeaways for FinTechs from the Climate Change Adaptation Report are summarised below.

Ramping up supervisory scrutiny from 2022

The PRA has made plain that it expects firms to be making significant headway against supervisory expectations (Supervisory Statement 3/19, Dear CEO letters, etc). Where firms are falling behind, or where remediation or assurance is required, then the PRA will consider the use of risk management and governance related capital scalars or capital add-ons, and/or the appointment of Skilled Persons (under s. 166 Financial Services and Markets Act). While the supervisory focus will be on larger financial institutions, FinTechs should note the regulators’ concerns around lack of strategic and organisation-wide consideration of climate-related risks and feed this into Executive Committee and Board-level considerations as you scale. 

Examining interlinkages between climate-related financial risks and regulatory capital

Over the course of 2022, the PRA and Bank of England will explore whether enhancements to the regulatory capital framework are required. The PRA considers that the current regulatory capital regime captures the consequences of climate change to some extent, including the accounting regime and through reference to the credit rating agencies. However, the PRA has pointed to two gaps - “capability gaps” (due to eg. lack of relevant granular data or modelling techniques that can fully incorporate climate factors) and “regime gaps” (challenges in capturing climate-related financial risks due to the design or use of methodologies in capital regimes themselves). There may be opportunities for FinTechs to address capability and regime gaps.

To inform the PRA and Bank of England’s thinking, in Q4 2022, the Bank of England will issue a call for papers and host a research conference on the interaction between climate change and capital. We expect the PRA to give an indication of the approach to regulatory capital before end-2022.

The Pensions Regulator: more work to be done

The shortest of the Climate Change Adaptation Reports, with less substantive detail provided, TPR indicated that the pension industry has more work to do to build resilience and assess climate-related risks.

Improving compliance through supervision and enforcement

TPR indicated that it will carry out a thematic review on scheme resilience to climate-related change. New questions will also be added to scheme returns to ensure compliance with disclosure obligations. 

New Code of Practice

TPR’s proposed new code of practice will include several climate-related modules in order to support Trustees in meeting their duties. TPR indicated it will work with the Department of Work and Pensions to share best practice on climate risk reporting.

Further information

If you have any questions or comments, please do not hesitate to get in touch at policy@innovatefinance.com. 

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