The European Commission Action Plan: An assessment of the reform areas for PRI signatories  provides an overview of the main areas of reform. Action 8 focuses on incorporating sustainability in prudential requirements.

Key points

  • The Commission will explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions’ risk management policies, and the potential calibration of capital requirements of banks as part of the Capital Requirements Regulation and Directive.
  • The aim would be to take into account such factors, where this is justified from a risk perspective, to safeguard the coherence and effectiveness of the prudential framework and financial stability. Any recalibration of capital requirements, based on data and the assessment of the prudential risk of banks’ exposures, would need to rely on and be coherent with the future EU taxonomy on sustainable activities.
  • In the third quarter of 2018, the Commission will invite the European Insurance and Occupational Pensions Authority (EIOPA) to provide an opinion on the impact of prudential rules for insurance companies on sustainable investments, with a particular focus on climate change mitigation. The Commission will take this opinion into account in the report to be submitted to the European Parliament and Council by 1 January 2021 under the Solvency II Directive.

Comment

Current EU prudential frameworks do not discriminate between green and brown investments. The thinking behind any potential change in prudential rules is based on the assumption that ignoring risks associated with climate change and other sustainability factors can create longer-term risks for financial stability and costs for banks and insurers whose assets are exposed to such risks.

However, any changes to prudential rules will be some way off. A precursor to any recalibration of bank capital requirements is the EU taxonomy on sustainable activities (due to be published in the second quarter of 2019). The Commission will also need to explore the feasibility of including risks associated with climate and other environmental factors in institutions’ risk management policies, and the potential calibration of capital requirements of banks, and balance these with ensuring that financial stability is safeguarded (under discussion in 2018-2019). Similarly, EIOPA will begin the process of forming its opinion on the impact of prudential rules for insurance companies on sustainable investment from mid 2018. The Commission will then report to the European Parliament and Council by 1 January 2021 as part of the process of updating the Solvency II Directive.

This part of the action plan has a substantial way to go. Changes to prudential rules, in combination with the taxonomy, would incentivise banks and insurers to shift their long-term investments into sustainable assets, but modifying prudential requirements on the basis of only one dimension of financial risk may create financial risk in the system. More work is needed.

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