The European Central Bank (ECB) has published its report on the state of climate-related and environmental (C&E) risk management within the European banking sector, a follow up publication to their supervision newsletter article published in August (The clock is ticking for banks to manage climate and environmental risks). The report covers 112 banks directly supervised by the ECB with €24 trillion of combined assets, and is based on the responses to a questionnaire circulated earlier in the year. The questionnaire consisted of a self-assessment of the banks current practices against the 13 supervisory expectations, together with a request to submit implementation plans detailing how and when the bank would meet these expectations. It provides a snapshot of European banks’ preparedness to adequately manage and disclose their exposure to C&E risks, shares examples of best practice, and highlights the areas where further progress is required.
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As noted by the ECB previously, almost all banks that participated in the exercise are only partially - or not at all - aligned with the 13 supervisory expectations (Guide on climate-related and environmental risks). Many of them do recognise, however, that C&E risks will have a material impact on their risk profile within the next three to five years, especially in terms of financing, day-to-day, and business model risks. The review found many of the banks who have chosen to report C&E risks as being irrelevant or immaterial have no proper risk materiality assessment in place.
The ECB notes banks progress in adapting governance policies and attributing formal responsibilities within their organisation for the management of these risks. Examples of the types of roles noted in the report include executive heads of sustainability, as well as supervisory and executive functions of the management body through specific directorates and committees. This formal ownership sends a clear message that the banks upper management are actively engaging with the new regulations and are aware of its impact.
The good practices noted in the report range from materiality assessment and strategy-setting procedures to specific qualitative and quantitative indicators in risk appetite statements and credit risk management. They highlight the importance of taking a strategic approach, especially in areas where data and methodological gaps are perceived to hinder the full implementation of the expectations in the short term. The examples demonstrate the ability of institutions to develop relevant risk management capabilities for the sound, effective and comprehensive management of C&E risks.
- Assigning specific C&E risk responsibility to members of the executive function and management body;
- Integration of C&E-related criteria in lending and investment policies. To alleviate market risks some banks are engaging in exclusionary or phasing out policies towards sectors they have deemed unsustainable;
- Engagement with corporate clients to ensure that each client has a dedicated transition plan (with a formal diversification strategy) in place; and,
- Integrating C&E risks into reporting practices in the form of gap analysis and data collection and reporting tools.
Areas where further progress is required
Biodiversity loss and pollution
The ECB found most institutions have a blind spot for physical risks and other environmental risk drivers, such as biodiversity loss and pollution. While institutions’ materiality assessments demonstrate that both physical and transition risks are often found to be material, their risk management practices for physical risks are less advanced than for transition risk. Transition risk refers to an institution’s financial loss that can result, directly or indirectly, from the process of adjustment towards a lower-carbon and more environmentally sustainable economy Institutions have generally started by collecting data and developing capabilities for transition risks. Conversely, only a handful of institutions have started taking into account other environmental risk drivers, such as biodiversity loss and pollution. For virtually all institutions, such other environmental risks are still a blind spot.
Data and methodological gaps
Some institutions have already made progress in this regard, for example by developing client scorecards with a qualitative risk classification (e.g. low, medium or high) or by using proxies as key risk indicators in the risk appetite statement. However, a considerable number of institutions have indicated longer lead times and do not plan to produce any short-term deliverables before the end of 2022.
- The ECB expects all institutions to take decisive action to address the shortcomings set out in a dedicated supervisory feedback letter, alongside a peer benchmarking issued in Q3 2021.
- The ECB have also announced they will perform a dedicated supervisory assessment on institutions’ public disclosures in the near future. In tandem with this the European Banking Authority is working towards the publication of Pillar 3 implementing technical standards (ITS) on ESG risks disclosures.
- The 2022 ECB stress test will focus on Climate Risk (Climate risk stress test - Methodology ) with submissions to the ECB beginning around March 2022, and feedback from the ECB issued later in the year. Examples of the questionnaires are also included in the Annexes of this report alongside instructions on how to fill in the templates for all three modules.
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Our team understands that regulation continues to drive the strategic agenda for banks. Working together with our dedicated Sustainability Team, we believe our skillsets combine the best of scientific knowledge with real world financial and regulatory experience to deliver practical, actionable solutions. We specialise in assisting clients across the financial services sector in navigating through the complex maze of C&E regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs.