Investing in energy: price, security, and the transition to net zero Contents

Chapter 4: Financial regulation

Bank of England regulators

172.Over the last decade, central banks have stepped up work on assessing and managing climate risk to the financial sector and exploring their roles in financing the transition to net zero.217 On 3 March 2021, the Government formally gave the Bank of England responsibility for supporting its net zero policy, as part of the Bank’s secondary remit.218

173.The Bank and financial regulators have been involved in several projects to improve their understanding of climate risk. These projects include setting out supervisory expectations for regulated companies, running a ‘green stress test’ to measure climate exposure, assessing the implications of net zero transition scenarios with international partners and supporting work on climate disclosures for certain companies.219 As part of this work, the Bank has identified two main types of climate risk to the financial system:

(1)Physical risks: arising from damage to property, land and other infrastructure as well as disruption to business supply chains and food systems. This could affect the soundness of financial institutions by reducing asset values and company profits, or through higher insurance losses.

(2)Transition risks: arising from the move to a net zero economy with changes in climate policy, technology and shifting consumer preferences. This could prompt a reassessment of the value of a large range of carbon-intensive assets and lead to higher costs of doing business. These could give rise to credit risk for lenders and market risk for insurers and investors.220

174.Since the publication of the Government’s British Energy Security Strategy on 7 April 2022, the Bank has been expected to have regard to supporting energy security as well as the Government’s net zero policy. The Chancellor instructed the Financial Policy Committee, which is responsible for the safety and stability of the financial system, to:

“have regard to the Government’s energy security strategy and the important role that the financial system will play in supporting the UK’s energy security—including through investment in transitional hydrocarbons like gas—as part of the UK’s pathway to net zero.”221

The Chancellor sent similar letters to the Prudential Regulatory Committee, which oversees policy for the Prudential Regulation Authority, and the Financial Conduct Authority, which regulates the conduct of financial services firms.222

175.The Bank of England has highlighted the risks of curbing finance for, and investment in, carbon-intensive industries too soon. For example, on 7 April 2022 Sarah Breeden, Executive Director for Financial Stability Strategy and Risk at the Bank of England, delivered a speech which explained some of the main risks that the Bank envisages for the financial sector from net zero policies, including:

176.In her speech Sarah Breeden concluded: “an effective transition requires the efficient allocation of capital to assets that are both green now and those that need greening, and the responsible retirement—over time—of assets which are not compatible with a net zero outcome.” She explained that more detail on the Government’s climate policies was needed, as was more transparency on firms’ approaches to managing climate risks.223

177.In a May 2022 speech Sam Woods, Deputy Governor for Prudential Regulation, said that while the UK’s energy system was in the process of deploying more renewables and energy efficiency measures:

“banks and insurers need to provide finance to more carbon-intensive sectors of the economy, precisely in order to allow them to invest in the transition. Cutting off finance to these corporates too quickly could prove counterproductive, and have wide-ranging macroeconomic and societal consequences, including through elevated energy prices”.224

178.While the Bank of England has made clear its awareness of these transition risks, it is less clear how it is including these perspectives in its policymaking. On 17 May 2022, Sarah Breeden told us that the Bank of England was still considering the Chancellor’s 7 April letter, in which he instructed the Bank to have regard to energy security. She said that ‘have regard’ letters are not necessarily designed to drive specific actions but set out factors that should be considered when making policy.225 On 5 July 2022, the Bank of England said it would “provide a formal written response to the recommendation when appropriate, in the usual way, as part of its response to the annual remit and recommendations letter.”226

179.We note the Chancellor’s decision to balance the Bank of England’s remit to support the transition to net zero with a requirement to have regard to its policies on energy security. Net zero and energy security are compatible objectives and well-designed supervisory policy can support their alignment. We recommend that the Financial Policy Committee, the Prudential Regulation Committee and the Financial Conduct Authority set out, at the earliest opportunity, high-level principles on how they are interpreting the Chancellor’s instruction on energy security.

Taskforce on Climate-related Financial Disclosures

180.The Taskforce on Climate-related Financial Disclosures (TCFD) was created by the Financial Stability Board in 2015227 with the objective of improving organisations’ public disclosures on climate impact. The TCFD believes better-quality disclosures will help investors to direct capital to more sustainable projects and business models. In June 2017, the TCFD published recommendations structured around four thematic areas: governance, strategy, risk management, and metrics and targets, alongside 11 recommended disclosures.228

181.The UK was the first G20 country to make TCFD-aligned disclosures mandatory for certain companies.229 Since 6 April 2022, over 1,300 of the largest UK-registered companies and financial institutions have been required to publish disclosures, including many of the UK’s largest traded companies, banks and insurers, as well as private companies with over 500 employees and £500 million in turnover.230

182.Ian Simm. founder and CEO, Impax Asset Management, told us that TCFD-aligned disclosures helped capital to flow towards sustainable investment opportunities “and away from where significant, unacceptable risk lies”. He said disclosures helped to ensure that regulators could “stay out of the divestment [from fossil fuels] debate and let the market decide.”231

183.Mike Zehetmayr, Financial Services Sustainable Finance Data and Technology Leader at EY, said that TCFD-aligned disclosures could help generate data from the private sector which will be needed by institutions to manage the transition to net zero and which were currently missing: “one of the key lessons that we have learned from the first implementation of disclosures for the European green taxonomy is that the data [do] not exist. Where [they do they are] poor quality, and in many cases, … qualitative rather than quantitative.”232

184.Positive Money, a think tank, was sceptical that it was possible to disclose reliable and accurate data on climate impact and thought that the Government was relying too much on voluntary efforts by the private sector to manage the transition. It said the belief that markets are efficient and can self-regulate was a false assumption.233

185.Sonja Gibbs, Managing Director and Head of Sustainable Finance at the Institute of International Finance, told us that “patchy data [are] better than no data; we have to start somewhere.” She highlighted “the huge array of data and service providers that are putting their heads together about ways to overcome these data gaps, including through some very sophisticated financial technologies.”234 Mike Zehetmayr agreed:

“over the last two years I have had a team who have been monitoring the third-party ratings and data market. Some 18 months ago, we were probably tracking about 40 providers. We are now tracking in excess of 110. There is a recognition in the market that there are gaps in the data, and there are traditional data providers that are using their extensive capabilities to outsource that data.”235

186.Mark Carney said the biggest challenge for developing useful disclosures was around collecting data for scope 3 emissions. Scope 3 refers to indirect emissions that occur in the value chain of a reporting company, such as emissions from suppliers and customers. They could include emissions from the extraction and production of purchased materials and fuels, transport-related activities in vehicles not owned or controlled by the reporting entity, electricity-related activities, outsourced activities and waste disposal.236 He said the Transition Plan Taskforce was supporting companies to gather these data.237 But it is far from clear how companies can assess scope 3 emissions.

187.The Government said in its 2021 Green Finance Roadmap that it plans to build on TSFD-aligned disclosures with new Sustainability Disclosure Requirements (SDRs). SDRs will broaden UK sustainability reporting, which currently focuses on climate-related risks, to cover a wider range of issues. They will also require companies to report on the climate impact under the proposed green taxonomy.238

188.Understanding climate risk and managing the transition to a lower-carbon economy requires data and appropriate analytic approaches, which disclosures will help to accumulate. HM Treasury and financial regulators will need to support businesses to make disclosures consistently. Businesses will need support on how to identify quantitative data on their climate impact, particularly in relation to scope 3 emissions which are especially difficult for companies to assess.

Green stress tests

189.The Bank of England’s Financial Policy Committee and Prudential Regulation Committee have jointly undertaken a ‘Climate Biennial Exploratory Scenario exercise’, or ‘green stress test’ to assess the resiliency of the financial system in three climate policy scenarios:

(1)Early-action scenario: climate policy is ambitious from the beginning. Global carbon dioxide emissions are reduced to net zero by around 2050 and global warming is successfully limited to 1.8°C, falling to around 1.5°C by the end of the century.

(2)Late-action scenario: the transition to a net zero economy is delayed by a decade. Policy measures are then more sudden and disorderly because of the delay. Global warming is limited to 1.8°C by 2050 but remains at this level at the end of the century.

(3)No additional action scenario: an absence of transition policies leads to a growing concentration of greenhouse gas emissions and global temperature continues to increase, reaching 3.3°C by 2050.239

190.Witnesses had different views on whether climate stress tests were useful. Mark Carney, UN Special Envoy for Climate Action and Finance and a former Governor of the Bank of England, told us that such tests enabled a “disciplined, rigorous approach” to assessing risk.240 Professor Sir Dieter Helm, Professor of Economic Policy at University of Oxford, said such tests could be useful but he thought there were more significant risks to the financial sector than climate change over the next 10–15 years.241 Michael Liebreich, Chairman and Chief Executive of Liebreich Associates, explained that there was a high level of uncertainty over which climate scenarios were realistic and central banks risked using “absurd” or “extreme” scenarios in their tests.242

191.The results of the Climate Biennial Exploratory Scenario were published on 24 May 2022. The Bank found that climate risk exposures will become a “persistent drag” on the profitability of banks and insurers. Overall loss rates were estimated to be 10–15% on average, annually.243 In a speech delivered on the same day as the results were published, Sam Woods gave his view on their significance:

“By themselves, these are not the kinds of losses that would make me question the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition. But any positive message needs to be taken with a major pinch of salt: both because there is a lot of uncertainty in these projections and because this drag on profitability will leave the sector more vulnerable to other, future shocks.”244

192.One of the goals of traditional stress tests is to assess whether financial institutions have sufficient capital to manage their exposure to risks. Regulators can set capital requirements to ensure firms have enough resources to help absorb financial losses over time, and which are designed to make the financial system resilient and protect depositors and policyholders.

193.Many central banks and regulators, including those in the UK, are assessing the role of capital requirements in managing climate risk. In October 2021, the Bank’s Prudential Regulation Authority published a consultation on whether to introduce changes to banks’ capital buffers to manage the impact of climate change; it will publish its findings by the end of 2022. The consultation said that the current capital framework covers climate-related financial risks but there are gaps which require research to see if further action is required. It added that capital framework is not the right tool to address the causes of climate change, but it could provide resilience against the consequences of climate change.245

194.Some witnesses told us that capital requirements were not appropriate to manage the climate transition. Sonja Gibbs said capital requirements that penalise more carbon-intensive investments and support more sustainable investment were “blunt tools” which would make it difficult to mobilise capital needed for the transition.246 Mark Carney told us that additional capital requirements may be necessary when there is greater certainty over what risks existed for the financial sector but did not think that certainty was present in the UK.247

195.The Climate Biennial Exploratory Scenario was not used to set additional capital requirements on the financial sector. Nevertheless, Sarah Breeden explained that the exercise would inform the Bank’s next steps in assessing climate risk management, including “whether additional capital is required”. Additional capital requirements were a “logical step, but there is some hard work to do before we jump to a logical step.”248

196.Sarah Breeden told us that the quality of the available data was not sufficient to judge how exposed the real economy is to climate risks. It made sense to “time [the Bank of England’s] further work in the light of getting better data”249 as it was currently “somewhere between hard and impossible” to identify which assets might be at risk from the transition without clear climate policy from Government: “As we have seen with energy security policy, as events change, transition pathways have to change … you have to be prepared to adjust them as the transition adjusts.”250 Sarah Breeden also told us that the financial sector will be most able to support the transition “where there is clarity and sufficient detail over the future path of policy.” She said this was a challenge for all governments around the world and not just the UK Government.251

197.In his May 2022 speech on the Climate Biennial Exploratory Scenario results, Sam Woods said that, while a drag on profitability would be “nasty” for the financial sector, a “fundamental recalibration of capital requirements” was unlikely to be needed so long as profits remained sufficient to protect capital buffers. However, higher capital requirements could be necessary if climate change made the “the distribution of future shocks” more severe, and further work was needed to assess whether sufficient capital was being held in the most climate-exposed parts of the financial system, even if the aggregate level of capital in the system was adequate.252

198.The quality of data and analytic approaches for assessing climate risks, especially transition risks, are insufficient for regulators to reach judgements on increasing capital requirements on the financial sector. The weakness of the data is exacerbated by a lack of clarity from the Government on energy needs during the transition and how sectors will be expected to adapt.

Green taxonomy

199.In a statement on 9 November 2020, the Chancellor set out plans to introduce a “green taxonomy”. This would define what “green” means to support companies and investors to understand better the effect of their investments on the environment.253 The Government provided more detail in its Greening Finance Roadmap, published in October 2021.254

200.Witnesses had mixed views on whether the opportunities provided by a green taxonomy would outweigh the risks. The Green Finance Initiative, which helped develop the taxonomy, said it could support investor confidence but would need to be “science based and robust”.255 Simon Redmond, Senior Director at S&P Global Ratings, said that a taxonomy could provide “a common set of rules” for companies, investors and other stakeholders, such as credit rating agencies.256

201.Dan Monzani, Managing Director, UK and Ireland at Aurora Energy Research, said green taxonomies “are generally helpful, but the real investments get made based on the real economics.” He explained: “if you put in place the right signals, carbon prices, policy supports and reforms to merchant markets, that will drive investment.”257 Taxonomies would “inevitably … be fairly simplistic”.258

202.Michael Liebreich, Chairman and Chief Executive of Liebreich Associates, was against green taxonomies because they “stifle innovation” by driving capital towards “a subset of solutions.” He warned: “the idea you can make a list of things that are always good, and therefore by definition a list of things that are always bad, is absolutely impossible.”259 Professor Sir Dieter Helm CBE, Professor of Economic Policy at University of Oxford, also said taxonomies could be simplistic:

“I would love to live in a world where something is either green or not green. It is simplistic to imagine that we can just decide that these are good and those are bad technologies. One has to look at how the technologies combine to take us on the pathway we want to go down.”260

203.Mark Carney, UN Special Envoy for Climate Action and Finance, had “some sympathy with the view that [taxonomies] may stifle innovation”, adding that they “have proven hard to adapt to be a true transition instrument to capture shades of green or shades of brown into green”. He thought a better approach would be to introduce net zero transition plans for companies and financial institutions, and to set transition pathways for economic sectors.261

204.Sonja Gibbs described green taxonomies as “political constructs” reflecting “different national priorities.” She explained that green taxonomies in different countries needed to be interoperable otherwise there would be opportunities for the private sector to ‘greenwash’ investments by exploiting differences in what is considered environmentally sustainable.262

205.Ian Simm, founder and CEO of Impax Asset Management, warned that public sector green taxonomies were “quite dangerous” because of the complexity of defining what is green “and the additional problem of boundary issues”. There was a risk of mission creep, as governments may feel pressure to orientate other policies around the taxonomy. He said there was also a risk of driving capital out of sectors that are needed during the transition.263

206.The Government’s green finance strategy said the UK taxonomy would be “objective and science-based” and would aim for “compatibility with other international frameworks”. It will include ‘enabling activities’, which recognise measures which support other sectors through the transition, but which are not yet sustainable themselves.264

207.The then Economic Secretary told us that the UK was involved in the formation of the EU’s taxonomy while it was a member state. In developing a UK taxonomy the Government would seek to define standards which are compatible globally, and as “accessible and transparent as possible for business so that, as far as possible, they do not provide duplicatory or additional cost to business.”265 There has been a debate about whether or not nuclear energy and gas can be included in a green taxonomy in the EU and that decision will also be an important one for the UK.266

208.Green taxonomies can help to provide investors with greater confidence to invest in sustainable projects, but they can also be seriously misleading by implying that projects and technology are either green or brown. If poorly designed, they risk driving capital to a narrow subset of existing options, which may stifle innovation and investment and they can fail to take account of the process of transition towards new sets of activities. The Government should be mindful of this risk by avoiding a narrow interpretation of the taxonomy and ensure that guidance to investors reflects the fact that the transition to net zero may involve complex trade-offs and interlinkages between renewables and fossil fuels. The Government should work with other jurisdictions’ authorities to ensure that the principles underpinning a UK taxonomy are consistent with other taxonomies: fragmentation causes confusion which can undermine investor confidence.

Solvency II

209.Solvency II is the regime governing the prudential regulation of insurance companies in the UK. It comprises EU legislation which has been transposed to UK law. HM Treasury has said that reform to Solvency II could unlock growth and investment in UK infrastructure and green projects.267

210.The Government published a consultation on 28 April 2022. It had three main proposals. First, it proposes easing solvency requirements by reducing the ‘risk margin’, which is an extra capital buffer that many insurers must hold, Second, it proposes reforming the ‘matching adjustment’, which allows insurers to reduce their long-term liabilities if they invest in certain assets. The Government proposes changing the eligibility criteria to allow long-term projects to be included in these portfolios. The consultation said:

“The Government wants to ensure that it operates to better enable insurance firms to play an appropriate role in the provision of long-term, productive finance to the economy and the provision of sustainable finance, consistent with the Government’s ‘levelling up’ priorities and its objectives to address climate change.”

211.The third reform is intended to reduce administrative burdens on companies, including doubling the thresholds at which insurers are included within the solvency regime.268

212.The EU is also carrying out a review of the Solvency II framework to ensure it offers greater flexibility and opportunities for investment in infrastructure and long-term sustainable projects.269

213.The Association of British Insurers told us that a “meaningful reform of Solvency II would substantially increase the capacity of insurers to provide long-term capital to underpin investments consistent with the Government’s energy strategy.” It said it could release £95 billion, which could be reallocated to invest in sustainable energy sources and infrastructure.270

214.Sarah Breeden told us that the reforms could lower capital requirements on insurers, enabling them to support additional investment in productive assets. However, “it is also possible that insurers might give that capital back to shareholders rather than put it to work”, and there was a risk of reducing the resilience of the insurance sector. She explained that it was necessary to strike a balance between unlocking capital for investment and protecting policyholders.271

215.Pension funds, although not directly affected by Solvency II reforms, are another source of long-term capital which can be used for investing in sustainable infrastructure. Occupational pension schemes in the UK hold almost £2 trillion in assets and the Government has said that they are the largest single group of institutional investors in the UK.272 The then Economic Secretary told us that to encourage defined benefit pension schemes to invest in long-term assets the Government, working with the FCA, is introducing rules and structures for long-term investment funds: “we very much hope asset managers will take up [the opportunity], and we hope that we will see funds launched imminently.”273 The ABI said the Government should ensure the criteria for “the long-term asset fund is as ambitious as possible”.274

216.The then Economic Secretary said that any reforms to Solvency II could unlock “several tens of billions that can be invested”, although he declined to provide a figure on how much. He said any reforms should not “drive more risk”; changes should be “reasonable” and “justified”.275

217.The Solvency II legislation is designed to protect policy holders and provide financial stability, but it also limits investment levels by major asset holders in the insurance sector. Reform of Solvency II will be the first significant change to the UK’s financial regulatory architecture following the UK’s exit from the EU. We agree with the Government that there is a significant opportunity to allow insurers to provide long-term capital to support investment consistent with the transition to net zero. The insurance industry has said such changes would release substantial capital, but we note that insurers do not have an obligation to use released capital for such investments. When it publishes the outcome of its consultation the Government needs to set out how it can encourage unlocked capital to support the energy transition.

217 For example, in December 2017 eight central banks, including the Bank of England, and supervisors established the Network of Central Banks and Supervisors for Greening the Financial System. It currently has 114 members and 18 observers

218 HM Treasury, Letter from the Chancellor to the Governor of the Bank of England (3 March 2021): [accessed 29 June 2022]. The Chancellor said, “Consistent with its objectives, the [Financial Policy] Committee should continue to act with a view to building the resilience of the UK financial system to the risks from climate change and support the government’s ambition of a greener industry, using innovation and finance to protect our environment and tackle climate change.”

219 For more information on this work, see Bank of England, ‘Climate Change’: [accessed 29 June 2022]

220 Elisabeth Stheeman, Speech on why macroprudential policy needs to tackle financial stability risks from climate change, 3 May 2022: [accessed 29 June 2022]

221 HM Treasury, Letter from the Chancellor of the Exchequer to the Governor of the Bank of England (7 April 2022): [accessed 29 June 2022]

223 Sarah Breeden, Speech on balancing on the net-zero tightrope, 7 April 2022: [accessed 29 June 2022]

225 Q 232 (Sarah Breeden)

226 Bank of England, Financial Policy Summary and record of the Financial Policy Committee meeting on 16 June 2022 (5 July 2022): [accessed 7 July 2022]

227 Financial Stability Board, ‘FSB to establish Task Force on Climate-related Financial Disclosures’ (4 December 2015): [accessed 29 June 2022]. The Financial Stability Board is an international body that monitors and makes recommendations about the global financial system. It was established after the G20 London summit in April 2009 as a successor to the Financial Stability Forum.

228 Task Force on Climate-related Financial Disclosures, Final Report Recommendations of the Taskforce on Climate-related Financial Disclosures (June 2017): [accessed 29 June 2022]

229 The Government’s July 2019 Green Finance Strategy included measures to prioritise environmental considerations in financial decision making, for example through stricter requirements on disclosing exposures to climate change risk. It also set out plans to encourage green investment and enhance the UK’s role as a centre for green finance. See, HM Government, Green Finance Strategy (2 July 2019): [accessed 29 June 2022].

230 HM Government, ‘UK to enshrine mandatory climate disclosures for largest companies in law’ (29 October 2021): [accessed 29 June 2022]

231 Q 122 (Ian Simm)

232 Q 147 (Mike Zehetmayr)

233 Written evidence from Positive Money (ESI0016)

234 Q 151 (Sonja Gibbs)

235 Q 151 (Mike Zehetmayr)

236 Task Force on Climate-related Financial Disclosures, Final Report Recommendations of the Taskforce on Climate-related Financial Disclosures (June 2017): [accessed 29 June 2022]. See also, Q 184 (Mark Carney).

237 Q 184 (Mark Carney)

239 Bank of England, ‘Results of the 2021 Climate Biennial Exploratory Scenario’ (24 May 2022): [accessed 29 June 2022]. In the exercise, the Bank of England’s estimates of financial sector losses assumed the balance sheets of banks and insurers would stay the same over the scenario time horizons, remaining as they were at the end of 2020. The Bank acknowledged that in practice banks and insurers would likely respond to climate risks over time, which would reduce losses.

240 Q 188 (Mark Carney)

241 Q 65 (Professor Sir Dieter Helm)

242 Q 128 (Michael Liebreich)

243 Bank of England, ‘Results of the 2021 Climate Biennial Exploratory Scenario’ (24 May 2022): [accessed 29 June 2022]

245 PRA, Climate-related financial risk management and the role of capital requirements (28 October 2021): [accessed 29 June 2022]

246 Q 151 (Sonja Gibbs)

247 Q 190 (Mark Carney)

248 Q 233 (Sarah Breeden)

249 Q 233 (Sarah Breeden)

250 Q 235 (Sarah Breeden)

251 Letter from Sarah Breeden to the Chair of the Economic Affairs Committee (21 June 2021): [accessed 29 June 2022]

253 HC Deb, 9 November 2020, col 621

255 Written evidence from the Green Finance Institute (ESI0034)

256 Q 113 (Simon Redmond)

257 Q 83 (Dan Monzani)

258 Q 82 (Dan Monzani)

259 Q 129 (Ian Simm)

260 Q 61 (Professor Sir Dieter Helm)

261 Q 191 (Mark Carney)

262 Q 152 (Sonja Gibbs)

263 Q 129 (Ian Simm)

265 Q 283 (John Glen MP)

266 On 6 July 2022, the European Parliament agreed to include nuclear and gas in the EU’s green taxonomy.

267 HM Treasury, ‘UK Government powers on with reforms to Solvency II’ (28 April 2022): [accessed 29 June 2022]

269 On 17 June 2022, the European Council agreed its position on the Solvency II reform proposals. Work to agree a final text with the European Parliament can now start. See, European Council, ‘Solvency II: Council agrees its position on updated rules for insurance companies’ (17 June 2022): [accessed 6 July 2022]

270 Written evidence from the Association of British Insurers (ESI0030)

271 Q 237 (Sarah Breeden)

272 Department for Work and Pensions, Consultation Stage Impact Assessment on Climate Change Risk – Governance and Disclosure (TCFD) Proposals (27 January 2021): [accessed 6 July 2022]

273 Q 284 (John Glen MP)

274 Written evidence from the Association of British Insurers (ESI0030)

275 Q 284 (John Glen MP)

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