Scope 3 capital design for carbon-emissions-facilitation tax risk

Abstract

[Abstract]: Greenhouse gas emissions drive climate change, so governments have introduced a large variety of carbon pricing instruments (CPIs): carbon taxes, emissions trading systems, and carbon credit markets. Banks finance a large percentage of global emissions, which is called their Scope 3 emissions, so governments may introduce a CPI on bank Scope 3 emissions. The possibility, i.e. this risk, of a Scope 3 emissions CPI is not covered in regulatory capital requirements today. Here we design an efficient Scope 3 capital charge to make banks resilient against the risk that governments introduce a Scope 3 CPI. We call this the Climate-Policy-Risk-Weighted-Assets (CPRWA) leading to Carbon Policy Capital (CPC). We focus here on the Trading Book, i.e. derivatives, although an extension to the Banking Book, i.e. loans, is a straightforward simplification. We develop a suitable mathematical framework, relative to future Scope 3 emissions in scope of the CPI. This requires new analytic expressions and Monte Carlo pricing. We provide numerical examples for interest rate swaps, for counterparties with high levels of emissions, in this case, transportation. The results show that an efficient CPC capital requirement would be significantly bigger than the currently used counterparty credit risk (CCR) capital. That is, CPC capital is comparable to CCR capital to make banks resilient against this government risk. We conclude that Scope 3 capital introduction needs urgent consideration by regulators.