cLIMATE AND ENVRIONMENTAL RISKS

How are European Banks Managing Their Climate and Environmental Risks?

This week, the ECB published its report on the state of climate-related and environmental (C&E) risk management in the banking sector[1]. Covering 112 banks directly supervised by the ECB with €24 trillion of combined assets, the report is an unprecedented stocktake of European banks’ preparedness to adequately manage and disclose their exposure to C&E risks. With the publication of this report, the ECB aims to offer an overview of the current trends in addressing and disclosing C&E risks within the euro area banking sector. It also intends to share some of the existing good practices in managing these risks in the hope that banks can draw inspiration from these to mitigate the gaps identified so far and to proceed more forcefully with their C&E risk management efforts.

This report has been compiled just one year after we published our Guide on climate-related and environmental risks for banks, demonstrating the ECB’s commitment – within its mandate – to making the financial system more resilient to these risks.

In the Guide, the ECB set out 13 supervisory expectations for the banks under its direct supervision regarding the integration of C&E risks into their business models and strategies, governance and risk appetite. As a follow-up to that Guide, the report published today presents the findings of the benchmarking exercise, which constitutes a thorough review of the practices and plans of the largest banks in the euro area and covers more than 130 areas of focus. In the context of this exercise, supervisors across all Joint Supervisory Teams covered by the exercise discussed the climate risk approach of the banks under their supervision as part of the supervisory dialogue for the first time.

Almost all banks that participated in this exercise are only partially – or not at all – aligned with the ECB’s supervisory expectations. 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 credit, operational and business model risk. Tellingly, of the institutions that report C&E risks as being immaterial to them, not a single one has an appropriate materiality assessment in place: they are either not comprehensive enough in their risk assessment or they haven’t even attempted to analyse the impacts of climate risk on their business at all.

Nevertheless, we do see that, most banks have started to adapt their practices to meet our supervisory expectations. But only the practices of a few have been shown to have a discernible impact on their strategy and risk profile. So far, banks have made most progress in adapting their governance and policies, while some banks have started to incorporate C&E risks into their lending policies and to attribute formal responsibilities within their organisation for the management of these risks. However, banks have been placing less emphasis on identifying and measuring these risks through a set of key risk indicators. And fewer than half of them have taken any steps at all to adjust their business model and strategic planning in the face of inevitably larger climate-related risks going forward. Banks have made the least progress in the areas of internal reporting, market and liquidity risk management, and stress testing.

The report also highlights the good practices identified regarding banks’ integration of C&E risks into their business models and strategies, governance and risk appetite, risk management and climate-related disclosures. Two-thirds of banks have made meaningful progress on integrating climate-related risks into their credit risk management. They have achieved this through measures such as enhanced due diligence procedures or new phasing-out criteria to limit the financing of activities that are highly exposed to climate-related risks. Likewise, banks are starting to assess energy label certifications when evaluating real estate collateral, although most don’t yet include the results in their lending and monitoring practices.

By publishing such an extensive and detailed set of information on the good practices identified across the euro area banking sector, the ECB hopes to close some of the gaps identified thus far and encourage banks to proceed more forcefully towards fully integrating C&E risks into their DNA. Because if one thing is clear from the supervisory expectations that we have issued, it is that we expect banks to ultimately manage C&E risks in the same way as any other material risk they face. What stems optimistic is that we observed good practices for each expectation and each of the 130 focus areas, demonstrating that there is a basis to build on to be found across the euro area banking sector for all expectations that the ECB has communicated.

Fortunately, by now almost all institutions have developed implementation plans to advance their risk management capabilities. We see that banks have made substantial efforts in this area and that they are actively attempting to proceed where gaps in data or methodology still exist. The quality of these plans varies across banks: only one-third of the largest banks in the euro area have developed plans that adequately address most of the existing gaps in their business strategy, governance, risk management and disclosure arrangements. What is more, only a subset of those have set formal targets to monitor progress over time. Worryingly, as many as 20% of banks still have significant gaps in their current practices, but do not have any credible plans to ensure the sound management of C&E risks in the foreseeable future.

Banks urgently need to set ambitious and concrete goals and timelines – including measurable intermediate milestones – to mitigate their exposure to current and future C&E risks. They will need to deploy forward-looking risk management tools that can capture longer-term risks, such as portfolio alignment approaches, and to closely monitor their strategic positioning against science-based transition pathways. To date, the majority of banks have no plans for concrete actions to adjust their business strategy. While half of the banks are contemplating setting exclusion targets for some segments of the market, only a handful of them mention actively planning to steer their portfolios on a Paris-compatible trajectory.

In this context, it is very welcome to see that the European Commission has put forward a proposal[2] for a legally binding requirement for banks to develop, implement and disclose their transition plans. Such transition plans should highlight banks’ alignment with and potential divergences from the relevant policy objectives through which the EU implements the Paris Agreement at any point between now and 2050. They should be part of a bank’s strategy-setting and closely linked to its business model and business plan. If the Commission’s proposal is adopted, the ECB will collaborate with other EU agencies to monitor banks’ progress in adapting to an economy that is transitioning to carbon-neutrality in order to avert the build-up of stranded assets on their balance sheets.

The ECB will continue to roll out its supervisory agenda on climate-related and environmental issues. In 2022 we will conduct a thematic review of institutions’ C&E risk management practices and a supervisory stress test with a view to gradually integrating C&E risks into the Supervisory Review and Evaluation Process (SREP) methodology. Once integrated into the SREP, banks’ exposure to C&E risks will eventually influence their Pillar 2 requirements.

Conclusion

The ECB views climate-related and environmental risks as key risk drivers for the banking sector – both now and in the future. Banks seem to be well aware of this, as shown by their materiality assessments. But many seem to have fallen prey to what the English classicist F.M. Cornford called the doctrine of unripe time to delay the right thing to do, whereby people argue that they “should not do at the present moment what they think right at that moment, because the moment at which they think it is right has not yet arrived”. This is clearly not the best way to tackle climate-related and environmental risk. Instead, paraphrasing F.M. Cornford, the argument for acting now is that it is the prudential thing to do. Inability to manage C&E risk poses a serious prudential risk to the stability of euro area banks and the banking sector as whole.

We are aware of the challenges linked to integrating C&E risks into banks’ strategies, governance and risk management arrangements. Today’s report will help banks to overcome those challenges. Moreover, financial institutions have more and more data and information available that they can use in designing strategies to concretely measure and manage their current and future exposures to C&E risks. The time is now ripe for banks to take comprehensive and forward-looking action on climate-related and environmental risks. The message of the report is clear: the time for action is now.

The report on the supervisory review of banks’ approaches to manage climate and environmental risks is available here.

Source: Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB

  1. ECB (2021), The state of climate and environmental risk management in the banking sector, November.
  2. Strategy for financing the transition to a sustainable economy, European Commission (July 2021)

Post Author: Wealth Monaco