The structure of our financial sector is fundamentally misaligned with the challenges and risks posed by climate change, and the Bank of England knows it.

In an unprecedented move by one of the world’s leading central banks, by next year the Bank of England could include the impact of climate change as part of its annual stress tests of the banking system.

If climate change is deemed to pose a systemic risk to our banking and financial system, banks could eventually be penalised for lending against carbon intensive activities, like fossil fuel extraction. 

It is difficult to underestimate the significance this positive step represents. However, as 60 academics recently suggested, the Bank needs to continue its commendable work as a global pioneer in this field – but not just as a thought leader, but through the action it takes.

The next steps for the Bank should be to take its worthwhile considerations and turn them into policy actions, as if our planet depended on it.

Climate breakdown and financial stability

Climate change has the potential to wipe out trillions of pounds worth of assets, making the devastation of the 2008 Global Financial Crisis seem like a walk in the park.

We can only burn one quarter of remaining fossil fuel reserves if we are to keep to the Paris Climate Agreement and stop temperatures rising above 2°C – even less if we are to keep to the considerably safer 1.5.

This poses severe financial risks: leaving most of the world’s oil, gas and coal in the ground means carbon intensive assets may be grossly overpriced – this is called the carbon bubble’ – and infrastructure built to extract the reserves may become useless (known as stranded assets’).

Losses could reverberate through the financial system, with approximately 30% of the market value of the FTSE 100 stock exchange directly derived from oil, gas and mining companies.

The impacts would not be limited to the fossil fuel sector alone, but would also indirectly affect industries that use carbon intensive inputs in their production – with potential to lead to losses in the trillions. By extending credit to carbon intensive companies, the banking sector is also exposed to these risks – which could potentially bankrupt the banking sector almost three times over.

But according to a recent survey by the Bank of England, only 1 in 10 banks are taking a long enough view of climate related financial risks. And perhaps more worryingly, while private sector credit rating agencies have started to acknowledge climate related financial risks, so far they have not reflected these in actual ratings.

Penalise dirty lending

Part of the Bank of England’s mandate is to ensure the financial system is safe and sound’. Given the potential impact climate change has for the financial sector, it is well within the remit of the Bank of England to take action.

Incorporating climate change into stress testing will help the Bank better understand the banking system’s exposure to the climate related financial risks referred to above. 

In the past the we have advocated for additional capital requirements for brown’ (carbon intensive) loans could be introduced. This is commonly known as the brown penalising factor’.

And the Bank of England’s governor Mark Carney has suggested that a brown penalising factor could potentially be incorporated into the Bank’s policy toolkit.

A brown capital requirement would work by compelling banks to back a proportion of their lending with shareholders’ equity (investment), ensuring that banks investors have more skin in the game’ when banks grant loans for carbon intensive activities.

Forcing banks to acquire more capital to grant a carbon intensive loan will make these loans more expensive for banks. With more of their own investment at stake, banks will be discouraged from making risky loans to carbon intensive sectors.

So if raised high enough, a brown capital requirement can significantly dampen the volume of loans that contribute to climate change. It would also reflect the growing risks of investing in carbon intensive activities and give banks a buffer to withstand climate related financial losses and the re-pricing of stranded assets.

But as we have highlighted, we need caution when fiddling with banks’ capital requirements. The converse — a lower capital requirement for green loans — is not advised, as it would not lead to a noticeable increase in sustainable investment. Instead, lowering standards for loans would risk weakening an already fragile banking system and undermining the still developing field of sustainable finance.

In light of the latest IPCC report and recent talks at COP24, it is good news that the Bank will potentially introduce climate change into stress tests and might consider introducing a brown penalising factor.

The Bank is clearly pioneering itself as a thought leader in this field; the next step is to turn these considerations into bold policy actions – not just to ensure the safety of our financial system, but to save the planet we inhabit.