Beyond Market-Based Sustainable Finance? Epistemic Conflicts and Financial Power in the EU Climate-Related Prudential Regulation

Prudential regulation for banks and insurance firms represented a crucial battlefield for competing policy paradigms in the development of the EU sustainable finance agenda. The recent reforms in banking and insurance prudential rules enshrined the failure of a substantive paradigm shift in the EU financial regulation. The proposals for full integration of climate-related risk factors in the calculation of capital and insolvency adequacy requirements, aiming to steer financing towards sustainable economic sectors, were dismissed in favor of a more market-based and case-by-case approach. The reforms’ outcomes thus strengthened a market-led paradigm of sustainable finance at the international level, discarding market-shaping interventionist policy. This paper intends to investigate and explain such a critical case of a failed paradigm change in the EU prudential regulation. To this aim, we build on critical political economy and strategic constructivist approaches to tease out the relationships between regulatory ideas and economic interests in the debate on climate-related prudential requirements. Through a combination of Bayesian process-tracing and discourse analysis, we reconstruct the emergence and conflicts between a market-based paradigm, sustained by a broad coalition of standard-setting institutions, financial think tanks, and financial industry’s lobbying organizations, and a contender market-steering paradigm, fostered by sustainability-focused think tanks, environmental organizations and initially supported by the European Commission and Parliament. We explain the demise of a more radical market-steering approach as the result of the European Banking Authority (EBA) and the European Central Bank (ECB) orientations. Both institutions played a fundamental role in shaping the EU policymakers’ consensus on a more market-friendly stance. According to our explanatory hypotheses, the EBA’s and ECB’s orientations have been shaped by a combination of ideational path dependence, privileging a precautionary stance against forward-looking models in climate-risk assessment, and financial industry pressures linked to the impact of climate-related prudential requirements on funding core non-green economic sectors. This paper thus sheds new light on the politics of failed paradigm changes in sustainable finance and the related intertwining of epistemic consensus, financial interests, and political power.