We Need Basel IV for Climate and Nature

Thought Leadership, Financial Risk & Reward, Policy, Transparency & Traceability, Multi-Asset

Like some banks, many species are too big to fail: their disappearance would lead to ecosystem and economic collapse. This is just one of the many reasons why banks should be subject to capital requirements adjusted for climate and nature risks.

New capital requirements for banks will factor climate risk

By the end of 2023, the Basel Committee on Banking Supervision (BCBS) will issue a consultation paper on climate-related disclosure requirements that it intends to add to international standards for capital requirements. This framework is expected to ‘complement, and be interoperable with, parallel disclosure initiatives under way by the International Sustainability Standards Board and other authorities’.

The consultation will focus on a draft Pillar 3 framework requiring disclosure of bank exposures to climate-related financial risks. There is no mention of nature-related risks despite many organisations recognising the interdependence between climate and nature.i Pillar 3 is part of the Basel Framework of standards for banking supervision which lays out a comprehensive set of public disclosure requirements that seek to provide market participants with sufficient information to assess an internationally active bank’s material risks and capital adequacy.

Planet Tracker welcomes the initiative of the BCBS to require disclosure of bank exposures to climate-related financial risks. Indeed, as concluded by the Cambridge Institute for Sustainable Leadership (CISL) and UNEP FI, the Basel Capital Accord does not address the financial stability risks associated with systemic environmental risks despite its overriding objective of banking stability.

However, we urge the BCBS to be more ambitious and include nature as well.

New capital requirements for banks should also factor nature-related risk

Currently, banks are not restricted when financing activities that contribute to ecosystem collapse via biodiversity loss. Yet, this is also clearly a systemic risk for entire economies and societies, not just the financial system. For instance, like banks, many species (called keystone speciesii) are also literally ‘too big to fail’: their disappearance would cause incalculable damages to humanity. Many pollinating insects such as bees are good examples of such species.

Many major banking institutions like DnBBanque de France, or the ECB have recently highlighted the importance of nature and biodiversity to parts of the financial system. Some members of the BCBS, including Finance Ministries, Central Banks and Supervisors, via the Network for Greening the Financial System (NGFS) acknowledge that nature risks could have significant macroeconomic effects and financial implications.

Planet Tracker therefore believes that banks should be subject to Basel rules for nature and climate for their own benefit – i.e. to de-risk the financial system on which they depend. Given the slow speed of implementation and the urgency of action, the earlier the BCBS can introduce such rules, the safer it is for the economic system.

Slow implementation

Consider indeed how slowly Basel III standards were implemented. The Basel III standards were published in 2010, after a consultation paper was released in 2009, in the wake of the 2007-08 financial crisis. Capital requirements were heightened under the Basel III rules, with minimum capital requirements for banks of 4.5% of common equity, as a percentage of the bank’s risk-weighted assets (RWA).

The voluntary deadline for implementing the new rules was originally 2015, but the date was repeatedly pushed back. It took seven years for the rules to be implemented in full by the fastest countries to do so (for instance, Argentina). In the meantime, in 2017, a reform to Basel III was published, which was due to take effect this year. Both the EU and the US are now targeting an implementation date of reformed Basel III rules by January 1, 2025.iii

In terms of an implementation roadmap, for climate-linked capital requirements we are now at the consultation paper stage, the stage at which we were in 2009 for Basel III rules implementation. Assuming a faster but nonetheless realistic implementation timeline, it is not before the mid-2030s that any climate-related requirements are likely to be broadly implemented. Let’s hope it is not too late.

Why is nature not included?

Planet Tracker believes that excluding nature is a significant oversight, for at least two reasons. The first is that nature and climate are inextricably linked – for instance, and at the risk of extreme oversimplification, via photosynthesis (the process by which terrestrial plants and phytoplankton combine water and carbon dioxide to form carbohydrates and give off oxygen).

The second is that every single economic activity is dependent on and impacts nature and climate, simply because they require humans who in turn require food, which relies on and impacts nature and climate. The commonly cited WEF report that about half of GDP is dependent on nature actually stated that such economic value is ‘moderately or highly dependent on nature’. The whole economy is dependent on nature, to varying degrees.

So why the oversight? The most likely answer for this ‘biocrastination’ is that nature risks are challenging to measure and their inclusion could go against the spirit of Basel III rules, which de facto assume that large, established companies (including agricultural companies or oil companies) are less risky than start-ups (including those working to decarbonise or restore nature) – when environmental impacts are omitted.

How to include nature in Basel rules

To change this, one could envisage a scoring system of every economic activity, mimicking the concept of RWA but from a nature and climate perspective by applying penalising factors. Let’s call it ‘Environmental Risk Weighted Assets’ (ERWA).

  1. The dirtier activities (those with the most negative impact on nature such as coal or deforestation) would be assigned a punishing ‘capital’ requirement, whilst cleaner projects (e.g. electric transport) would be assigned a lower ratio. Importantly, restorative projects would be assigned a negative ratio (i.e. would be positive in terms of ‘capital’ requirements).
  1. Standard ERWA weightings would be calculated for each type of activity.
  1. Once ERWAs are calculated and the relative weightings for each of them decided, a bank would be required to assign capital accordingly.

This would effectively penalise banks for lending/investing in environmentally-damaging projects and accelerate the scaling of truly green projects: given their lower capital requirements, they could be offered at lower interest rates.

That hierarchy in capital requirements and returns would then trickle down the financial system as it would make the financing of the ‘dirtier’/cleaner activities costlier/cheaper, and therefore raise/lower the cost of their capital and ultimately their cost of operating.

It would also address the question of offsets, or rather internalise it directly within the strategy of banks, instead of dedicating a few millions to ‘be net zero’ via sometimes questionable offsets (long-term) while pursuing destructive activities in the short term.

Is it feasible? Recent economic papers suggest it is.

A challenging exercise

But of course, challenges abound.

Measurement is the key one. To address this, we would suggest incorporating metrics that track the five key drivers of biodiversity loss (which include climate change), and as aligned as possible with the Kunming-Montreal Global Biodiversity Framework (GBF). Inevitably, there will be a need for arbitrary decisions on some activities, but the same goes for some of the Basel III framework. In May 2023, UNEP FI published ‘Banking on Nature’, to help financial institutions understand the relevance and implications of the GBF, by providing banks with an overview of how the GBF applies to the financial industry, through the perspective of risk, opportunities, dependencies and impacts.

The need for third party verification for measurements/computations of ERWA is another obvious challenge, but not an impossible one to address: external auditors would need to be involved.

Perhaps the greater challenge in our view, is that by favouring nature-positive companies, ‘Basel IV Environment’ rules would typically favour smaller companies vs. large, established industries (e.g. fossil fuels) vs start-ups, which goes against the spirit of existing rules (where smaller companies are considered riskier). Adequately incorporating considerations of size as well as type of activity is therefore key. Of course, this means that ‘Basel IV Environment’ rules would be prone to be lobbying targets: accommodating weightings for damaging activities could damage the spirit of these rules, as shown by the EU’s Green Taxonomy, or the weakened Nature Restoration Law proposal in the EU.

Finally, the introduction of factors that penalise environmentally destructive practices would (rightly) challenge the current landscape of environmentally harmful subsidies (e.g. in excess of USD 1 trillion for fossil fuels in 2022), possibly leading to a conflict between monetary and fiscal policies.

Could it work?

Influencing banks’ decisions via capital requirements is a strategy that works. For instance, the 2017 requirement of systematically important Brazilian banks to incorporate environmental risks in their capital adequacy assessments led to a lending reallocation by large banks away from exposed sectors, which was not observed at smaller Brazilian banks.

That is why we urge the BCBS to be more ambitious and incorporate broader nature risks, not only climate risk in their upcoming consultation.

Failing to incorporate nature risks is tantamount to ignoring a major systemic risk. Scheduled for the end of this year, the Basel Committee’s consultation paper is therefore a unique opportunity to ensure the stability of economic and financial systems by incorporating the health of the ecosystems on which these systems ultimately depend.

ii Keystone species have a disproportionately large impact on its environment, often holding ecosystems together

iii Many refer to the reformed Basel III as Basel IV but the BCBS recommends to stick to Basel III, which is why we do it too.

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