Financing the transition to net zero: new guide published

There is no doubt the finance sector has a significant role to play in meeting the challenges raised by the climate change emergency and the transition to net zero.

This week saw the publication of an important guide which frames the problem for the UK financial services sector and proposes a number of practical solutions: for regulators, for industry and for government. The guide has been published by the Climate Financial Risk Forum, which is co-chaired by the FCA and the PRA and comprises banks, insurers, asset managers and others such as the Green Finance Institute and the LSE

The guide has been divided into four sections: Risk management; Scenario analysis; Disclosures and Innovation.

The first three of these will assist UK firms in understanding how they should approach climate change risks with respect to their own organisations. They are designed to be complementary to existing frameworks such as the UN PRI (UN Principles for Responsible Investment) and the TCFD (Taskforce on Climate-related Financial Disclosures).

The innovation chapter will be of particular interest to the wider market as it addresses how to unlock finance to help the transition to net zero.
A summary of each section and our thoughts are set out below.

Risk management

This chapter of the guide outlines how firms can approach designing and implementing a governance approach for climate risks akin to that used for established financial risks. It sets out what "good" looks like and the implementation steps needed to achieve that – illustrated by a number of case studies and examples.

There is also a useful section on risk assessment and the data and tools which could be used in that task. A separate list of some of the available tools has been published alongside the chapter (the list is not exhaustive and no endorsement is indicated by inclusion on the list).

Scenario analysis

This chapter complements the risk management chapter in that it develops an important – and one of the most challenging – aspects of a firm's climate change risk strategy. The iterative and circular nature of the process involves: first, identifying potential exposures; second, developing suitable scenarios; and third, assessing the financial impact. This then feeds back to identifying exposures. The authors acknowledge the daunting nature of the task and helpfully lay out a three stage approach to help firms get started quickly on their analysis.

Disclosures

A number of mandatory climate-related disclosure requirements apply in the UK. These work in tandem with voluntary guidelines and public/investor expectations. This chapter of the guide provides guidance on what firms could be doing to strengthen their disclosures in light of those requirements.
The annex of the chapter contains a very useful and detailed analysis of the UK legal frameworks for disclosure. It sets out what needs to be disclosed and by whom; the purpose of disclosures; the judgements to be made in assessing materiality; where disclosure may be made; and the liability and litigation risks that may apply.

Innovation

This chapter sets out the many existing challenges that are preventing the industry from financing the transition to net zero, and proposes a number of practical recommendations. Some interesting highlights are:

• Working with the UK Green Finance Institute's CEEB group to expand and create new financial instruments to unlock the finance needed to retrofit housing in UK: for example, by expanding the green mortgage market.
• Reducing the relative cost of capital for green homes by including energy costs in loan-to-income ratios so that energy performance becomes a fundamental part of mortgage lending.
• Recommending that HM Treasury works with the PRA to create a credible UK 'green bond' market at scale through the issuance of green gilts and more favourable regulatory capital treatment. (This is identified as a priority task for the next 12 months.)
• Dealing with regulatory constraints on pension schemes which prevent them from investing meaningful amounts in illiquid assets such as infrastructure and private investment opportunities.
• The importance of the role of government in setting clear policy signals and frameworks, such as clear dates for phasing out internal combustion engines. The government also has an important role in underwriting (akin to export credit guarantees) or taking first loss risk or credit support on investment programmes to crowd in private finance while ensuring there is a suitable risk/reward profile for private capital – with Thames Tideway financing given as an example.

Osborne Clarke comment

Despite the involvement of the FCA and the PRA, the guide does not have the status of regulation. This may tempt some to view it as just another piece of voluntary guidance. However, the detail and breadth of the analysis means it will be invaluable to any organisation seeking to address climate change risks. Most importantly, we see the ideas highlighted in the innovation chapter as materially moving the conversation forward on what can be done to finance the transition to a low-carbon economy.