Financial Services Bill

Baroness Hayman Excerpts

Report stage
Wednesday 24th March 2021 Lords Chamber

[Lord Oates (LD)]

My Lords, I declare my interest as the chairman of the advisory committee of Weber Shandwick UK. Amendment 3 is in my name and the names of the noble Baronesses, Lady Hayman, Lady Jones of Whitchurch and Lady Altmann. I thank all the organisations who provided me with briefing, in particular Finance Watch for its helpful advice and recommendations.

Before I speak to Amendment 3, I also want to express support for other amendments in this group, particularly Amendments 22 and 23 in the name of the noble Baroness, Lady Hayman, which deal respectively with climate risk reporting and the appointment of a senior FCA manager responsible for climate change. I have been pleased to put my name to both.

In Committee we had an excellent and productive debate about the impact of climate risk on the financial system and the wider economy. I am grateful to the Minister for his careful consideration of the arguments, and to noble friends and colleagues across the House for the excellent cross-party co-operation we have achieved on these issues. I thank the Minister for listening to the arguments on the need for the FCA and PRA to have regard to the UK’s 2050 net zero obligations and for introducing government amendments to achieve this end. That is a great step forward.

If we are effectively to respond to the existential threat climate change poses to our financial system—indeed, to our whole human society—finance will be critical in allocating the huge amounts of capital required to decarbonise the global economy. Today, however, finance is the principal enabler of climate change by financing the global warming-accelerating activities of the fossil fuel industries at an artificially low cost as a result of the inadequate pricing of climate risk within the financial system.

As long as capital adequacy risk weights are inconsistently applied within the capital requirement rules so that fossil fuel activities are under-risked, capital will flow towards them because the equity that has to be held on the bank’s balance sheet will be less than it should be and the return on equity consequently better than it should be. As a result, capital which could be better employed in the new technologies we will need to counter climate change will continue to be misallocated to the old industries that drive it.

Amendment 3 attempts to address this problem by requiring the PRA to complete a review of capital adequacy risk weightings in relation to existing and new fossil fuel investments within six months of the Bill being passed. That review would aim to ensure that risk weights for fossil fuel investments adequately take into account the impact of global warming-accelerating activities on financial stability, in particular as a result of climate change-related disruption to the economy.

This amendment is an attempt to meet the concerns of the Minister over my more direct amendment in Committee, which called for specific risk weights to be applied to fossil fuel investments in line with the existing capital adequacy rules of the capital requirement regulations, or CRR. The amendment in Committee required the application of a 150% risk weight to existing fossil fuel investment, in line with Article 128 of the CRR. That requires such a risk weight to be applied to

“items associated with particular high risk”,

for example, hedge funds or investments in immovable property.

It is clearly hard to argue that fossil fuel investments are less risky than either immovable property or hedge funds investments, given the likelihood of fossil fuel assets becoming partially or wholly stranded. The logic of CRR is, therefore, that such investments must be included under Article 128. That they are not indicates that the regulatory system is struggling to respond to the complex and interrelated risks posed by climate change to the financial system.

The original amendment also proposed that, for new fossil exploration and production, the risk weight should be applied such that investment in these activities would have to be backed by 100% equity on the lender’s balance sheet. Such a risk weight is merited by the fact that new fossil fuel investments are likely to become entirely stranded and that exploitation of new fossil fuel investments would push us far beyond the level of two degrees of warming that the Intergovernmental Panel on Climate Change warns us would have enormous and unpredictable consequences for human society, not to mention the banks and the financial system as a whole. It is right in those circumstances that the resulting loss of capital should be effectively ring-fenced so that the problem is confined to the bank equity holders and not allowed to spread to depositors and the wider financial system—adding a financial crisis to a climate crisis.

It is fair to say that the Minister and a minority of other Peers were resistant to the direct approach to risk weights I proposed. The Minister was concerned, as was the noble Baroness, Lady Noakes, that we were seeking to use prudential regulation to achieve policy objectives that they felt were better pursued elsewhere. The noble Baroness stressed that the system of prudential regulation should be about the

“risk to the capital of the banks and the resilience of the financial system as whole.”—[Official Report, 1/3/21; col. GC 244.]

To this, I can say only that I agree; that is the precise purpose of the amendments that my noble friends and colleagues across the House and I have been pursuing.

Last week, the deputy governor for prudential regulation and CEO of the PRA Sam Woods stated in a speech to the Association of British Insurers that

“it is a fundamental pillar of the prudential regime that it be risk-based: disregarding the risk in individual investments is a recipe for an under-capitalized financial system that would not be a robust or sustainable source of investment.”

I agree with the deputy governor, just as I agree with the Minister. My only difficulty is that the disregarding of risk in individual investments, which the deputy governor warns us against, is exactly what is happening in respect of fossil fuel investment because prudential regulation has not worked out how to adequately assess the impacts of climate change on the financial system.

The scale of the problem was highlighted by Mark Carney in his “Breaking the Tragedy of the Horizon” speech some years ago. He said:

“Take, for example, the IPCC’s estimate of a carbon budget that would likely limit global temperature rises to 2 degrees above pre-industrial levels. That budget amounts to between 1/5th and 1/3rd world’s proven reserves of oil, gas and coal. If that estimate is even approximately correct it would render the vast majority of reserves “stranded”—oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics. The exposure of UK investors, including insurance companies, to these shifts is potentially huge.”


Is anyone seriously suggesting that these risks are currently being properly taken into account in the capital adequacy risk weights? If they were, it is inconceivable that existing fossil fuel investments would not be ranked under Article 128 of CRR as items associated with particular high risk. Of course, investments in new fossil fuel exploitation pose not only micro-prudential risks to banks arising from stranded assets, but the huge macro-prudential risks due to the acceleration of climate change which they will cause.

The Minister sought to assure us in the debate in Committee that the regulators have these matters under control. He prayed in aid, as did the noble Baroness, Lady Noakes, the climate scenario tests that the Bank will be conducting later in the year. These are no doubt worthwhile exercises and it is good to see that the Bank is setting the international pace. But these scenario tests will not fix the issue.

Although the Governor of the Bank implicitly recognises the role that capital adequacy requirements need to play in addressing climate-associated risks when he says that supervisory expectations will require firms to assess how climate risks could impact their businesses and to review whether additional capital needs to be held against this, he also states that, in relation to climate scenario tests, the Bank will not use them to size firms’ capital buffers. The reason the Bank is reluctant to do so is the difficulty of using such tests to measure hard-to-quantify future risk. So we have a dangerous scenario when regulators say that they cannot act until they can adequately measure risk, and on the other hand that the risk is too difficult to measure. The route through this is to apply the existing capital adequacy risk weights in an internally consistent manner, as proposed by the amendment that we put at Committee.

Although I stand by that position because I believe it is the only logically coherent and feasible way of dealing with risk in respect of fossil fuel activities, I have listened to the Minister’s arguments and those of the noble Baroness, and consequently I have put forward this revised amendment to require the PRA instead to conduct a review of the issue of risk weights and climate change and report back to the House. This will provide an opportunity to consider carefully the issues raised and also to inform the debate on risk weights at international level. I hope the Minister will see merit in this proposal.

I made it clear in Committee, and I stress again on Report, that neither my amendment then, nor the revised version before your Lordships today, is driven by any animus against the fossil fuel industries—quite the contrary. I have a huge respect for the people working in those industries and a huge determination that there should be a just transition for those employees as we decarbonise our economy. We will be able to achieve that much more easily if the financial system shepherds an orderly transition away from fossil fuel industries through the appropriate application of risk in the system.

I understand the reluctance of the Government to intervene in prudential regulation, but Ministers cannot abdicate responsibility. They must not cling to the idea that the technicians have got this under control, because it is an illusion—and it is an illusion that will have disastrous consequences if it is not corrected. When the system of prudential regulation is so evidently failing in its primary task of managing and controlling risk in the financial system, at least in respect of climate risks, there is an obligation to act. So I am hopeful that, having listened to the arguments during the debate, the Minister will accept the case for the review and provide sufficient assurance that this will be taken forward in a timely manner. However, if he is not able to do so, I give notice of my intention to test the opinion of the House. I beg to move.

[Baroness Hayman (CB) [V]]

My Lords, I remind the House of my interests as co-chair of Peers for the Planet. I have Amendments 22 and 23 in this group and will speak also to the government amendments and Amendment 44, from the noble Baroness, Lady Bennett. I have added my name to Amendment 3, to which the noble Lord, Lord Oates, has just spoken so powerfully.

Before I speak to any of the amendments, I will thank colleagues, the noble Lord, Lord Oates, and the noble Baronesses, Lady Jones, Lady Altmann and Lady Bennett, who have added their names to my amendments. I thank very particularly the Minister and his team for their very approachable actions in relation to discussions since Committee. They have been engaged in a sensitive and constructive way, and the noble Earl, as we have come to expect, has always been extremely courteous, endlessly patient and generous with his time. I think we have made real progress because of that.