Net zero transition plans: a supervisory playbook for prudential authorities
Net zero transition plans are set to become a key part of the pathway to implementing the Paris Agreement. Just as governments need detailed plans to show how they will deliver their net zero targets, corporations and financial institutions need to inform stakeholders how they plan to adapt their business model to a rapidly changing environment and mitigate transition risks.
Transition plans have largely been treated as a tool for non-financial disclosure to date, but there is ample scope to make more use of transition plans for prudential purposes. This report discusses how prudential supervisors could use prudential transition plans as an additional dynamic instrument to assess, address and bring distant financial risks into the present. It outlines steps, in the form of a Supervisory Playbook, towards incorporating transition plans into prudential supervision. This could enable supervisors to effectively use the benefits of transition plans as a forward-looking methodology to better manage and overcome some of the challenges associated with climate risks.
- A transition plan is a detailed multi-year account of targets and actions that sets out how a given firm will ensure that its business model and strategy are compatible with a specific environmental objective, such as the goal of limiting global warming to 1.5°C.
- The primary rationale for the financial sector to align operations with net zero commitments made by governments is to anticipate investment opportunities and mitigate transition risks.
- In supporting prudential supervisors, transition plans can aid the identification of misalignment with net zero that may result in short- and medium-term risks; a prudential supervision focus on alignment could serve as a proxy for assessing banks’ long-term risk; and transition plans can provide supervisors with a better understanding of aggregate alignment of the banking system as a whole.
- Three different types of transition plans are starting to emerge: voluntary, market-led net zero transition plans; mandatory corporate disclosure net zero transition plans; and mandatory prudential transition plans that focus on the risks of misalignment with net zero targets.
- While all three types of transition plan are evidently relevant for the work of prudential supervisors, this report emphasises the strategic importance of prudential transition plans for assessing, monitoring and addressing banks’ alignment with a sustainable transition.
- Climate- and environment-related risks (C&E risks) raise new challenges for prudential supervision, including their long time horizon, the limited effectiveness of current, backward-looking risk management approaches, and the lack of available data concerning the materiality of climate and environmental risk.
- The prudential supervision of C&E risks through transition plans offers an additional supervisory tool, complementing the emerging use of forward-looking scenario analysis and stress testing.
Recommendations to prudential supervisors
- Prudential supervisors should pay close attention to net zero transition plans because they can aid the identification of misalignment with net zero that may result in short- and medium-term risks. A prudential supervision focus on alignment could also serve as a proxy for assessing banks’ long-term risk. Furthermore, transition plans can provide supervisors with a better understanding of aggregate alignment of the banking system as a whole.
- There are three steps for prudential supervisors to integrate transition plans into their practices:
- They should first set supervisory expectations for prudential transition plans to ensure they are fit for prudential purpose.
- Supervisors should then undertake supervisory assessment of prudential transition plans to determine whether financial institutions are exposed to risks in the context of alignment with the applicable government’s transition pathway.
- Then they should take steps to mitigate the risks to which banks whose plans indicate acute and significant transition risks are exposed, utilising the micro- and macroprudential toolbox.
- As net zero transition plans are developed further, it will be important for the prudential community to be active participants in the design of ‘what good looks like’ so that they can play their full part in addressing climate risks.