EBA Discussion Paper

ESG in risk management and supervision: another step in the sustainability journey

While 2021 has seen a focus on climate change like never before, the wider topic of sustainability and the integration of sustainability-related risks is also high on the regulatory agenda for banks and investment firms . Environmental, Social and Governance (ESG) considerations are both all-encompassing and a permanent part of financial services activities, transformation, and risk management. A key development in this area was the publication of a Discussion Paper on ESG risks management and supervision by the European Banking Authority (EBA) in November 2020. The primary aim of this paper was the collection of feedback for the preparation of a final report on the topic by 26 December 2021[1]. Firms should also note that the planned report forms part of the EBA's Action Plan on Sustainable Finance, which includes work on Pillar 3 disclosure requirements for ESG risks and dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives.

What’s involved?

The paper outlines two core elements, in the form of common definitions and indicators, metrics and methods, which together will form the basis for how risk management (at firm level) and supervision (at regulator level) are conducted in this area going forward.

The key definitions introduced are as follows (with these being interconnected in nature):

  • ESG factors are environmental, social or governance characteristics that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual e.g. production of CO2 emissions, floods;
  • ESG risks materialise when ESG factors affecting institutions’ counterparties have an impact on the financial performance or solvency of institutions e.g. environmental risks.

ESG factors and risks are linked through the prism of ‘transmission channels’; physical (the physical effects of climate change), transition (uncertainty related to the timing and speed of the process of adjustment towards a low-carbon economy) and liability (people or businesses seeking compensation for losses they may have suffered from the physical or transition risks from climate change).

While the definitions outlined form the building blocks of ESG risk management and supervision, the indicators, metrics and methods to be utilised are where institutions and firms will see the major effects of the new ESG approach. For example, the EBA has included an indicative, non-exhaustive list of ESG factors, indicators and metrics in the paper, which will help in the linking of factors to risks. A number of methodological approaches for assessing the ESG risks are also outlined, including portfolio alignment, risk frameworks and exposures.

When deciding upon an overall holistic approach to the management of ESG risk, it is important for institutions and firms to bear in mind that there is no ‘one-size-fits-all’ approach available – addressing this area in a comprehensive and efficient manner will involve careful consideration and analysis of business models and risk processes.

It is also important to note that ESG risks are to become subject to comprehensive supervision from both the ECB and national competent authorities, particularly in the spheres of business models, governance structures and risk management.

What will be expected of banks and investment firms?

EBA ESG What will be.png

Why Grant Thornton?

Grant Thornton’s Financial Services Risk, Consulting and Advisory teams are comprised of dedicated experts who are experienced in supporting banks and investment firms with a variety of regulatory challenges.

In particular, our industry-leading Prudential Risk team understands that regulation continues to drive the strategic agenda for banks and investment firms. ESG and other sustainability related areas are likely to be high on the regulatory agenda for years to come. They specialise in assisting clients across the financial services sector in navigating through the maze of regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs.

[1] The timeline for the report includes; a consultation period, which closes at the start of February 2021; delivery by the EBA of its post-consultation findings in June 2021; and, then follow up with its final report.