Rationale and Design of a Scope 3 Capital Charge

Regulators set capital levels to ensure that banks are "sufficiently resilient to withstand losses in times of stress''. Climate change is caused by greenhouse gas emissions, and governments have introduced over seventy carbon pricing instruments (CPIs). Banks finance a significant fraction of global emissions, and many have committed to reduce their facilitated, or Scope 3, emissions to (net) zero by 2050. However, it is possible that governments will introduce a CPI impacting banks on their Scope 3 emissions before 2050. Here we design a Scope 3 capital charge to make banks resilient against the possibility, albeit not certainty, that governments could introduce such a Scope 3 CPI. We focus here on the Trading Book, i.e. derivatives, although extension to the Banking Book, i.e. loans, is a straightforward simplification. Our numerical examples, based on interest rate swaps, are financially significant for counterparties with significant emissions. Scope 3 CPI capital can move from a fraction of SA-CCR capital (for 100% risk weight then RWA times 8\%) to multiples of SA-CCR capital as contract move from 5, to 10 or 20 year maturities. Governments may provide limited notice of a Scope 3 CPI introduction since climate change is an external challenge which the CPI would be intended to combat. Thus Scope 3 capital introduction requires urgent consideration by regulators, and the contribution of this paper is to provide a technical basis for banks to be sufficiently resilient