ECB Draft Guide on climate related and environmental risks

In the wake of the European Green Deal, and its objective of making Europe the first climate-neutral continent by 2050, the European Central Bank (ECB) recently consulted on its proposals for a Guide on climate related and environmental risks[1].

This follows the work being done by the European Banking Authority (EBA) – as part of its Action Plan – to incorporate Environmental, Social and Governance (ESG) risks within the three pillars of prudential supervision, specifically in the areas of strategy and risk management, disclosure, scenario analysis and stress testing.  

The ECB’s proposed guide contains far-reaching expectations for banks. Meeting these will entail factoring climate-related and environmental risks – as drivers of established categories of prudential risks – within the business strategy, governance and risk management framework. Institutions will also be expected to publish meaningful, transparent disclosures on exposure levels and on how they manage these risks.

The guide will not be binding for institutions. However, the ECB will engage with significant institutions on implementation as part of its supervisory dialogue. The ECB will also leverage the guide as it develops a supervisory approach to management and disclosure of climate-related and environmental risks.

What are the recommendations?

The ECB has set out 13 main expectations in its guide – these are summarised below:

Our commentary

We support the ECB’s aim to improve the management of climate-related and environmental risks across the banking industry. Our response to the consultation addresses the following key points:

Timing of compliance with the guide

Institutions are expected to begin aligning their practices with the ECB’s expectations upon final publication of the guide in Q4 2020, with the ECB starting its supervisory dialogue with significant institutions from end-2020. While the ECB is not requesting full alignment with the guide over this period, the timescale proposed will leave banks with little time to develop effective plans for adoption, collect the required data and build relevant modelling tools.

Materiality assessment

The ECB will expect institutions to consider material climate-related and environmental risks during strategy-setting. However, “materiality” is an arbitrary notion subject to varying interpretations among institutions. It would be helpful for the ECB to provide further guidance on what constitutes an exposure that is materially exposed to climate or environmental risk, perhaps in the form of a materiality threshold. The ECB could also clarify that this guide focuses mainly on institution-level risks.

Encouraging best practice by less significant institutions

The ECB could support less well-resourced institutions in their adoption of the guidelines by publishing a guidance document on ESG risks, and by promoting supervisory dialogue between less significant institutions and national competent authorities (NCAs).

Expectations on capital adequacy

The ECB recommends that banks identify and quantity climate-related and environmental risks within their overall process of ensuring capital adequacy. In our view, it would be beneficial if the ECB could also clarify whether capital add-ons are likely to be required in relation to climate and environmental risks.

Calculating the borrowers default risk

The ECB will expect banks to consider climate and environmental risks when calculating the probability of default. Banks’ ability to follow this expectation may be limited in practice due to a lack of historical data for back testing and difficulties in risk prioritisation. The ECB could specify in its guide that risk assessment is expected to reflect actual risks that are modellable, and recommend the use of scenario analysis where there is insufficient historical data.

Loan pricing frameworks

For the ECB, loan pricing frameworks should fully reflect the risk appetite and business strategy on exposure to climate-related and environmental factors. This strategy could be further developed within institutions by defining, for example, lower internal transfer rates for risk for financial products or loans to “low-risk” (e.g. less pollutant) counterparties. This would allow banks to better manage the impact of their distribution of financial products on the sustainability of banks’ business models.

Views on the role of the first line of defence

We welcome the ECB’s recommendation on defining roles and responsibilities for the first line of defence with respect to climate risk. We suggest the ECB specify the need for a clear definition of the tasks and responsibilities of all lines of defence, notably in terms of risk-taking and managing climate-related and environmental risks in their policies, procedures and controls.

The bigger picture

In some countries, regulators have already begun to implement requirements that mirror the ECB’s expectations. An example is the United Kingdom, which is not part of the Single Supervisory Mechanism but whose regulatory framework is relatively advanced on sustainable finance. In 2019 the Prudential Regulation Authority (PRA) published a Supervisory Statement[2] outlining its expectations that banks embed financial risks from climate change into their existing financial risk management practices. The Statement also includes expectations on climate-related scenario analysis, governance and disclosure practices.

At the European level, the EBA is also taking measures to improve sustainability risk management and disclosure. In its 2021 work programme published recently[3], the EBA identifies ESG risks as one of its six strategic areas of work. The EBA plans to assess the potential inclusion of ESG risks in the supervisory review and evaluation process performed by NCAs, and submit a report to the European Commission, Parliament and Council by 28 June 2021[4]. Furthermore, the EBA is working to identify key metrics (qualitative and quantitative) and associated disclosure requirements for banks, which will be applicable from June 2022. Finally, the Authority is assessing whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified, and will publish its final report on this by June 2025.

What firms need to do now

Starting from end-2020, significant institutions will be asked to inform the ECB of any divergences of their practices from the expectations outlined in the guide. In view of the short timeframes for implementation currently envisaged by the ECB, large institutions supervised by the ECB should begin to assess where their current risk management and disclosure practices may need to be enhanced.

The ECB has also recommended that NCAs adopt these expectations in their supervision of less significant institutions. This would be applied proportionately, considering the risk profile and business model of each firm. As such, smaller institutions should consider which sections of the guide are most relevant to them and begin to address any gaps identified in these areas.

[1]https://www.bankingsupervision.europa.eu/legalframework/publiccons/html/climate-related_risks.en.html

[2]https://www.bankofengland.co.uk/prudential-regulation/publication/2019/enhancing-banks-and-insurers-approaches-to-managing-the-financial-risks-from-climate-change-ss

[3]https://eba.europa.eu/about-us/work-programme/current-work-programme

[4]https://eba.europa.eu/eba-pushes-early-action-sustainable-finance