By Gordon Noble
In 2022 the impact of changes to embed climate risk into the Byzantine world of international financial system regulation will start to be felt. Understanding exactly how and why financial system regulation changed in 2021 is a key to understanding what is in store in 2022.
Amongst all the changes we witnessed in what was a turbulent year, the changes that took place to embed climate-related financial risks into the supervisory practices of financial system regulators and standard setters are perhaps the least examined and understood. Whilst over the course of 2021 attention on climate change was naturally drawn to Glasgow and COP26, the rules of the global financial system were being quietly re-written to lock- in consideration of climate change.
The process of change began innocuously enough. On 25 January 2021, just a couple of weeks after the confirmation of President Biden, the Federal Reserve Bank of New York announced that Kevin Stiroh had been appointed to lead a Board of Governors on Climate.[i] The Federal Reserve then announced on 23 March 2021 that it was establishing a Financial Stability Climate Committee (FSCC) to identify, assess, and address climate-related risks to financial stability.[ii] By the end of the year the powerful Financial Stability Oversight Council (FSOC), which was established as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, had issued its Report on Climate-Related Financial Risk. [iii]
Internationally as the Italian Government prepared to host the G20, a largely unknown study group on sustainable finance was transformed to become the G20 Sustainable Finance Working Group.[iv] This was no ordinary working group. Its members, including the Bank of International Settlements (BIS), Financial Stability Board (FSB), OECD, World Bank and the International Organization of Securities Commissions (IOSCO), effectively govern the global financial system. What has been largely underappreciated is that the working is co-chaired by China and the United States.
In the lead up to COP26 the G20 SFWG produced its Sustainable Finance Roadmap which was endorsed by G20 finance ministers and central bank governors on 7 October 2021. The Roadmap outlines a pathway of how the G20 will embed climate change into the activities of financial system regulators and standard setters. Up until now the approach of international financial system regulators on climate change has been characterised by the lack of coordination. The way to describe the G20 SFWG is that it is the ‘one ring to bind them’. Importantly the Roadmap commits that the SFWG will produce a Synthesis Report which will report on progress each year. The appendixes of the Roadmap outline in detail the activities that will take place over the next few years and which agency will be responsible for driving them.
Two significant developments are the support by financial system regulators for the establishment of the International Sustainability Standards Board and the release by the Basel Committee on Banking Supervision of the draft “Principles for the effective management and supervision of climate-related financial risks” which was released on 16 November 2021.
There is no doubt that the drive to integrate climate-related financial risks into financial system regulation is coming out of the United States. The EU was already active in this space, but until the US engaged its efforts have struggled to gain momentum. One explanation as to why the US is moving so fast is the volatility of US politics. If climate-related risk management is locked into international financial system regulation, then this one way to ensure that momentum on climate change continues whatever happens in future Presidential elections.
The implication for responsible investors is that consideration of climate change is shifting from a voluntary to a compulsory activity. ESG practices have largely been developed outside of government. In fact, it is arguable that one reason why ESG achieved such dominance as an investor paradigm is because regulators largely left it alone. The reality is that whilst investors control what they invest in, it is financial system regulators that establish the frameworks within which investment takes place. An analogy is the building of a canal. It can take a while for the engineers to work out where to build. During the time taken to construct a canal it is easy to question whether the canal will have impact. But once the canal is built and is operational the flow of water is unstoppable.
[i] https://www.newyorkfed.org/newsevents/news/aboutthefed/2021/20210125
[ii] https://www.federalreserve.gov/newsevents/speech/files/brainard20210323a.pdf
[iii] https://home.treasury.gov/system/files/261/FSOC-Climate-Report.pdf
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