Financial Services and Markets Bill

Baroness Worthington Excerpts

Committee stage
Wednesday 1st March 2023 Grand Committee

Moved by

[Baroness Worthington]

168: After Clause 50, insert the following new Clause—
“PRA dutiesReview of capital adequacy requirements risk weights and solvency capital requirements
(1) Within six months of the day on which this Act is passed the PRA must complete a review of the risk weighting and capital requirements applied to loans, guarantees or investment via shares or securities in—(a) group undertakings engaged in existing fossil fuel exploitation and production,(b) group undertakings carrying out new fossil fuel exploration, exploitation and production, and(c) group undertakings otherwise at significant risk from the low carbon transition, including but not limited to those engaged in fossil fuel-based power generation, agriculture, automotive engineering, aviation and heavy industry.(2) In conducting this review, the PRA must have regard to—(a) the full implications of climate change for the risk of investments including physical climate risks, transitional climate risks and climate liability risks,(b) the likelihood of assets becoming wholly or partially stranded before the end of their normal cycle,(c) the impact of climate change and climate change-related disruption on financial stability, and(d) the advice of the Climate Change Committee.(3) The Treasury must lay before Parliament the outcome of this review within one month of its completion.”Member’s explanatory statement
This amendment requires the PRA to complete a review of the risk weighting and capital requirements of banks and insurers in relation to firms engaged in financing fossil fuel exploration, exploitation and production alongside other climate-risk exposed sectors, taking account of the climate risk on those investments and on financial stability, the likelihood of the assets becoming stranded, and the advice of the climate change committee.

[Baroness Worthington (CB)]

My Lords, moving on to a different set of topics, Amendment 168 is in my name, and I am grateful to the noble Baronesses, Lady Sheehan and Lady Drake, for lending their support. This is the only amendment in the group which has my name on it but I am broadly supportive of many of the others in it, as they seek to address a broad range of questions relating to how risk is taken into account in financial services regulation, with a specific focus on climate risk, as in my amendment.

Amendment 168 is about the risk weighting of assets for the purposes of capital adequacy requirements, in the case of banks, and solvency capital requirements, in the case of insurers. It is not a terribly prescriptive amendment. It would require the PRA to complete a review of these matters in relation to loans, guarantees or investment in firms engaged in new and existing

“fossil fuel exploration, exploitation and production”

and other sectors which are particularly exposed to low-carbon transition and climate risks

“including but not limited to those engaged in fossil fuel-based power generation, agriculture, automotive engineering, aviation and heavy industry”.

Proposed new subsection (2) sets out a number of matters to which the PRA should have regard, including the different types of climate risk and the risks to both individual stranded assets and wider macroeconomic financial stability. It also requires it to take advice from the Climate Change Committee. I have referred to loans, guarantees and investments in relation to the group undertakings to capture particular climate risks in the wider groups of firms. A loan to a firm engaged in clean technologies is still exposed to financial risk if it is a wholly owned subsidiary of a firm which is significantly exposed to low-carbon transition, or if the firm itself owns firms which are.

To be clear, I am seeing this through the lens of financial risks to firms. I have noted that Sam Woods, the chief executive of the PRA, has said that the organisation should not seek to pursue a climate policy in stealth mode or on the quiet, as a second Government, unless government gives it that duty. He says that the PRA and Bank of England remits are currently to pursue financial stability and accordingly to manage climate risk, which has the potential—I go so far as to say the likelihood—to constitute a huge risk to financial stability. I agree with him, but I do not believe that, for the management of these risks, the tools that the bank has deployed to date are sufficient; in fact, they include methodological issues that are disastrously understating the financial risks.

Before I turn to that issue, I should address one other point. During the passage of the Financial Services Act 2021, an amendment in relation to capital risk requirements was tabled by the noble Lord, Lord Oates. In response, some Peers said that there was no emergency embedded in banks’ balance sheets, as corporate lending in short to medium-term in nature. However, I need to emphasise that significant impairments are possible in both the short and medium-term.

This is not only as a result of more unpredictable and extreme weather—more particularly, it is as a consequence of technological and societal change. Global investment in low-carbon technology has increased by 20% a year in the past five years alone, and has now overtaken global fossil fuel investment. There is a whole economy change under way. It is not about a few companies and discrete sectors that have failed to take into account incremental improvements but about whole sectors exposed to broad-based technological change, increasing the rates of company failure, and the rapid shrinking of some industries, accompanied by the expansion of others. Banks and insurers that have not taken account of such changes face much higher impairments and, given the systemic risks of allowing them to fail, socialised public bailouts. It is right that the PRA should assess that these risks are being adequately managed and that the banks and insurers participate in supporting that review. It is about investing a little now to avoid spending a lot further down the road.

How are these risks being managed? Currently, through the climate biennial exploratory scenario, or CBES. In this exercise, the PRA offers up sample temperature rise scenarios and underlying assumptions of the implications for different assets, and firms plug in their portfolios to get the impairment data out as a result. This all feels safe and precise, but the climate is something that cannot be predicted specifically in those ways with any degree of accuracy. It is about the extent and nature of the risks that must be taken into account. This whole streamlined, reassuring and seemingly precise approach is hopelessly wrong in the face of climate risk.

A paper by the noble Lord, Lord Stern, of this House highlights that the methodologies employed by such climate risk models rest on flawed foundations, with huge error bars and unknown unknowns. Critical methodological problems have led to perverse outcomes, such as the suggestion that a 3 degree temperature rise, global average, offers the optimal balance of benefits and costs. That is more or less what we get from CBES. Where temperature rises are limited to under 2 degrees or rise to more than 3.3 degrees, the drag on company profits is predicted to be at around 10% to 15% on average. I have no idea how any model could reach that conclusion that had any bearing with what is actually happening to our physical climate.

Let us remember that the economy and the financial markets are a wholly owned subsidiary of our natural environment, and we are now in a destabilised climatic environment. This same 3 degree rise, which is the global consensus, involves steep drops in food production, dire water shortages, a sharp increase in urban heat waves, forced migration and mass extinction events. An increasing body of literature sets out why the models do not work. The former chief economist of ING Group in a Policy Exchange publication concludes that central bank scenarios have so far been based on assumptions and models that ignore or downplay crucial evidence of climate risks—notably the rising frequency of extreme weather events and critical triggers, tipping points and interdependencies between the climate, the economy, politics, finance and technology.

That is true for the CBES model. The underlying assumptions in the CBES paper highlight minimal economic impact from inaction on climate change over the next 25 years and a reduction in GDP growth of only 0.12% in 2050—another ludicrously precise number, given all the future uncertainties that lie ahead of us. That is very poorly aligned with the scientific consensus. Other academics have identified dangerous underlying assumptions in the functions that feed into those used by CBES, including that 90% of GDP will be unaffected by climate change because it happens indoors, and using the relationship between temperature and GDP today as a proxy for the impact of global warming over time, ignoring any possibility of cascading climate feedbacks and tipping points.