Regulatory and Policy Initiatives to Address Sustainability-related Risks and Opportunities

November 27, 2023

Achieving net-zero carbon emissions by 2050 requires a deep economic transformation, substantially impacting financial systems. Financial sector regulators and supervisors have important roles to play in enhancing the resilience of the financial sector to climate-related shocks and building a foundation of transparent and fair markets for investment in transition finance.

Financial supervisors should incorporate climate-related financial risks into the prudential framework. Sound financial institutions are paramount to a smooth green transition and long-term resilience of economies to climate change. As financial risks are increasingly influenced by climate change, the prudential framework needs to be enhanced to ensure that financial institutions are well-equipped to weather climate-related shocks and remain able to provide financing for the required transition to a low-carbon and sustainable economy. Experience shows that even simple supervisory actions can trigger a meaningful response from financial institutions and better climate-risk management.

The Basel Committee on Banking Supervision Principles for the Effective Management and Supervision of Climate-related Risks provide specific guidance for supervisors and banks. The standard sets out 18 principles covering corporate governance, internal controls, risk assessment, risk management, and reporting. It extends and further specifies the Basel Core Principles for Effective Banking Supervision, while building on previous analytical reports and the work of the Network for Greening the Financial System. This provides a common set of high-level principles and guidance for banks and supervisors, while retaining sufficient flexibility given that practices in this area are heterogeneous and evolving. Basel Committee member supervisory authorities should implement these principles through adapted supervisory guidance and monitoring, considering the specific risk profile of each jurisdiction regarding the impact of climate change, as well as the principle of proportionality.

The International Association of Insurance Supervisors (IAIS) and the Sustainable Insurance Forum (SIF) published the Application Paper on the Supervision of Climate-related Risks in the Insurance Sector in 2021. This builds on a limited number of Insurance Core Principles covering supervisory review and reporting, corporate governance, risk management, investments and disclosure and provides background and guidance on how the Insurance Core Principles can be used to manage the challenges and opportunities arising from climate-related risks. The IAIS and SIF continue to work on deepening guidance for supervisors. The IAIS is working on three packages of additional material for supervisors including a consultation earlier this year on amendments to the Insurance Core Principles to incorporate climate-risk considerations directly in the Principles covering corporate governance and risk management; and recent consultations on climate scenario analysis and market conduct issues related to climate risk, notably covering the risk of greenwashing. SIF is working on guidance for transition plans and surveying the extent that Pillar 2 requirements are incorporating climate-related risks in practice.

The quality and availability of climate-related data and information remains a challenge where supervisors can play an important role. Evaluating physical and transition risks requires information that is currently largely missing. Our experience from the Financial Sector Assessment Program, as well as technical assistance work, shows that lack of relevant climate data is common across jurisdictions. Better information will help identify the threats to financial stability posed by climate change, improve market confidence, and foster sustainable finance. International standards on climate-related disclosures were issued by the International Sustainability Standards Board this year and build a global framework for reliable and comparable data around sustainability-related risks and opportunities. Interactive and focused dialogue between supervisors and the industry should be enhanced, particularly to plug data gaps. Supervisory reporting should be tailored to each jurisdiction, depending on the risk profile and supervisory needs. In order to be helpful, data and information must be granular enough and adequately forward-looking.

Scenario analysis is a critical aspect of the supervision process. Historical trends and parameters are unlikely to hold under most climate-risk scenarios. Financial institutions should address climate-related risks in a forward-looking manner and supervisors should challenge the assumptions they use in managing risks and setting strategies and business models. The NGFS has designed scenarios for assessing the impact of climate change on the financial sector and has updated them several times. The scenarios can be a useful reference for supervisory authorities to set up a forward-looking assessment toolkit, consistent with a risk-based supervisory approach. The IAIS application paper currently under consultation builds on this work in an insurance context.

The role of transition planning is becoming increasingly important in risk management. Transition planning includes (i) the internal strategic planning and risk management processes undertaken by a firm to prepare for both risks and potential changes in business models associated with the transition to a lower carbon economy, and (ii) the “transition plan” as the firm’s tangible output of the transition planning process. The Basel Committee principles already provide guidance around strategic planning and comprehensive risk management processes that banks should undertake to prepare for transition, and additional supervisory guidance on transition planning is being considered. Such as in the areas of forward-looking risk identification, client engagement, and climate scenario analysis, or how transition planning could be a useful source of information to supervisors.

Securities market regulators can create a foundation of transparent and fair markets for transition finance. Disclosure standards should be strengthened to ensure availability of relevant, accurate, and comparable information on climate risks and opportunities for investors to take an informed decision. The regulatory framework for intermediaries and markets relating to climate products should be strengthened along with improved supervision and enforcement with respect to greenwashing. Fair, efficient, and transparent transition finance markets with adequate investor protection safeguards will help boost the funding for the climate transition.

Regulators and supervisors need to allocate adequate resources for building effective supervisory capacity. Considering the enormous breadth and depth of the expertise required for developing climate-risk supervision, setting dedicated action plans is warranted to build capacity in the medium term, while incorporating evolving international standards, methodologies, and practices that are still being developed. Supervisory authorities need to connect interdisciplinary knowledge, and, for a complex nature of climate-related topics, to be able to capture the depth of the issues. Action plans related to climate-risk supervision need to be inclusive for all functions of organizations, starting from the top. On our side, through our capacity development work, delivered in part by regional centers, the IMF provides guidance to financial sector regulators and supervisors on how to conduct climate-risk analysis and adjust their frameworks in line with the Basel Committee’s Principles for the Effective Management and Supervision of Climate-related Financial Risks. Over time, technical assistance will incorporate other international standards as they evolve.

All climate-related initiatives of supervisory authorities should be consistent with their core mandate which consists primarily of ensuring financial stability. Actions of supervisors need to be consistent with their legal mandate. Prudential supervisors should focus on their core mandate of promoting a safe and sound financial system; securities regulators on creating fair and transparent markets with adequate investor protection safeguards. While supervisors should play an active role within their respective mandates, financial regulation and supervision should not be used as substitutes for effective government policy on climate change.

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