Shifting the trillions: financial regulation reforms in the UK and their relevance for climate action
What role can and should financial regulation play in tackling climate change? The answer should guide the remoulding of regulatory bodies in the UK. Rob Macquarie and Brendan Curran outline what recent proposals for reform could mean for a socially just, climate-resilient, and net-zero transition.
Last year, the UK Government declared a “new chapter for financial services” and set out its plans for a new approach to regulation in the Future Regulatory Framework Review.
Two major changes have triggered this agenda. First, the UK’s exit from the European Union provides an opportunity to change both its approach to and the letter of financial regulation. Through the process of amending ‘retained EU law’, Parliament will move the EU directives that formerly governed the UK’s financial services sector out of the statute books. Regulations that the UK would like to keep will be set in the rulebooks of its two regulators: the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The second change behind the Government’s new approach is the need to align the financial sector with reaching net-zero emissions, in the drive to make the UK resilient to climate change and ecological breakdown. The UK, as a rich country with advanced climate policies and a large and highly developed financial centre relative to the size of its economy, is at the forefront of the global investment push for the climate and ecological transition. In addition, management of climate-related and nature-related risks must be integrated into all decision-making by firms and policymakers alike. Both components of alignment are essential for a sustainable path towards future prosperity.
In this light, some of the proposals in the Review need to be handled carefully. Our response to the public consultation launched by HM Treasury notes two areas of risk, one concerning the objectives the Government intends to give the regulators, and another linked to the accountability of their decision-making tools. There is also an opportunity: to enable the regulators to consider the links between social factors, such as reducing inequality and ensuring a just transition from carbon-intensive to low-carbon sectors, with an agenda that is sensitive to climate and nature.
New objectives for the FCA and PRA
A cornerstone of the Government’s plans for the future framework is its intention to legislate new objectives for the FCA and PRA. These would require those authorities to “act in a way that, subject to aligning with international standards and so far as is reasonably possible, facilitates the long-term growth and international competitiveness of the UK economy, including the financial services sector”. These would be secondary objectives, subordinate to the existing primary objectives.
However, there are dangers in such an approach. Regulators and financial firms must adopt a broad and long-term view, rather than narrowly emphasising industry profitability or GDP growth over a limited period. The risks of a regime unduly focused on short-term competitiveness were clearly seen in 2008, when financial crisis engulfed the UK banking system.
As for the net-zero transition, the Government plans to modify an existing principle that the regulators must take into account when discharging their functions. That principle already notes the desirability of sustainable growth, but it would be adjusted to ensure consistency with the commitment to achieve a net-zero economy by 2050. The Government’s explanation for these proposals is inconsistent. In making the case for a new objective concerning growth and competitiveness, the Review notes that ‘principles’ do not provide a strong enough requirement for the regulators to act. The question remains why a new objective is deemed necessary for ‘growth and competitiveness’ when sustainable growth is already among the regulatory principles – and why a principle is considered sufficient incentive to create regard for net-zero.
An effective focus on growth and competitiveness in the long term is entirely consistent with proper regard for net-zero, climate change adaptation and biodiversity goals. The only way to retain international competitiveness over the coming decades is for that growth to be inclusive, sustainable and resilient. Apparent tensions are illusory, since the integrity of the financial and economic system is highly dependent on an orderly transition, and on limiting global temperature rise and ecological collapse. However, a preferable step would be to use a new secondary objective to clearly prioritise sustainable growth and consistency with the net-zero goal, climate resilience, and restoring biodiversity. Doing so would circumvent any threat from a narrow interpretation of competitiveness.
Tools and accountability
Some essential new tools for climate change mitigation and adaptation will come to the fore in the work of both regulators, as a host of new standards, measurements and tools will be needed in the coming years to achieve alignment.
For instance, the FCA will need to assess and support standardised metrics, to ensure that emissions reduction claims are disclosed in a consistent manner, green financial products serve their purpose, and to clarify what constitutes effective investment in resilience. On the supervisory side, the PRA should assess financial firms’ transition plans, soon to become mandatory, as a key step towards establishing a strategic approach to climate risk management. Greenwashing in any field is harmful to consumers, to the integrity of the transition, to financial stability, and to future economic growth.
The regulators’ performance against their objectives will be scrutinised by Parliament and external stakeholders, and their duties subject to recommendations by HM Treasury. Amid a debate over whether a new Parliamentary committee is needed for effective oversight, the Government’s proposals remain agnostic as to the appropriate structure. Clearly, whichever objectives are embedded in new legislation will frame future contests over the FCA and PRA’s actions.
Cost-benefit analysis (CBA) is another important, conventional tool used by policymakers of many stripes to make decisions, and will continue to have a place in financial regulation. The Government has proposed a new statutory panel to review and make recommendations on the regulators’ use of CBA. Such extra transparency may seem welcome. However, it is vital that any new mechanism does not introduce systematic bias against environmental action (which has plagued economic policymaking on climate change for too long) or allow private actors to capture the process. The best way to introduce feedback on CBA appears to be a panel with diverse membership that would review the regulators’ methodologies after decisions have been made, allowing for learning and refinement over time.
Social links
Finally, the Review is an opportunity for Government to also recognise social factors as an under-appreciated risk to the financial and economic system, and as being essential to protecting the beneficiaries of financial services. If policymakers and regulators do not consider the social risks, impacts and opportunities from a transition to net-zero, then they risk the transition being inefficient in delivery or even risk it not being implemented. In particular, delivering the transition to net-zero in a manner that is just and reduces inequality is critical to the efficiency of delivery.
Here, regulation can follow other recent decisions and policies, such as the ‘green plus’ reporting framework for the Government’s Green Gilt and NS&I’s Green Savings Bond. The new Framework could be a moment for the FCA and PRA to consider financial sector practices and their impact on sustainable growth in a holistic sense, including the benefits or risks for people and places. Adopting this lens would help regulated financial institutions to fully integrate the environmental and social dimensions of the transition into their policies and decision-making.
By considering these factors and embedding climate and nature with strong provisions at both regulators, the new Framework can live up to its name, and create a flourishing financial sector fit for the growth of the future.