ECB urges banks to speed up managing ESG risks

ECB thematic review on climate-related and environmental risks

The ECB published the findings of its thematic review on climate-related and environmental (C&E) risks on 2 November (see here). The review follows the publication of the ECB’s guide on C&E risks that was published in November 2020 (see here) and which outlined the central bank’s view how financial institutions should integrate C&E related risks in their business strategy as well as governance and risk management frameworks. As such, it lays the foundations for the ECB’s way of supervising banks (or institutions) on C&E issues.

The results of this year’s thematic review were incorporated in the ECB’s 2022 Supervisory Review and Evaluation Process, SREP), which have an impact on Pillar 2 capital requirements. As such, the review clearly reflects the increased importance that the central bank attaches to management as well as governance of climate-related risks for banks. The sample included 186 banks, of which 107 significant institutions and 79 less significant institutions. Furthermore, the assessment was based around four core modules (i.e. materiality assessment, business environment and strategy, governance and risk appetite, and risk management framework) and three risk-specific modules. Finally, the modules were assessed from three different perspectives, namely their ‘soundness’ (i.e. existence and quality of the practices in the light of supervisory expectation), their comprehensiveness (i.e. extent to which the practices cover all material portfolios and risk drivers), and their effectiveness (i.e. whether the practices are effectively implemented in practice).

Overall, the ECB’s verdict was that there are still many gaps in banks’ assessments of C&E related risks, despite the fact that 85% of banks have in place some basic practices to assess C&E risks (see the graph below). The shortcomings range from the methodologies used, to execution capabilities as well as effective implementation of C&E risk mitigating practices. The ECB has sent feedback letters to all banks, which includes on average 25 shortcomings per institution. Furthermore, the ECB expects financial institutions to take decisive action to address shortcomings, setting a deadline at the end of 2024 when banks need to be fully aligned. In the meantime, the central bank has set intermediate milestones, namely:

• End of March 2023, when banks need to have incorporated sound and comprehensive materiality assessment

• End of 2023, when banks need to be able to ‘manage C&E risks with an institution-wide approach covering business strategy, governance and risk appetite, as well as risk management, including credit, operational, market and liquidity risk management’

One of the key concerns of the ECB is about the capabilities of banks to execute risk management related to C&E risks. While many banks have made progress in their action plans to incorporate C&E risk management, the progress has remained limited and perhaps more importantly, more than half of institutions have not effectively implemented these. The ECB notes that although this might be partly related to rapidly changing landscape of C&E risk management, it is more likely related to more fundamental weakness in the implementation of C&E risks through their entire organisations. Indeed, the third line of defence plays only a minor role in this respect, if any. Please find below some key findings for the four core modules in the report.

Materiality of C&I risks

The first module assesses whether banks measure in a proper way the materiality of C&E risks across the banking organisation. In this respect, the review showed that 90% of institutions conducted a basic assessment of material C&E risk for at least one of their key risk types. This was mostly related to credit risk as well as strategic risks, and less so for liquidity risk or market risk. However, there remain a large number of blind spots, or risks that are not being included in materiality assessments, implying that banks do not have a comprehensive picture about the possible impact of C&E risks on their organisation. Indeed, 96% of institutions had blinds sporty, of which the ECB considered 60% to be major gaps).

The main gaps stem from the fact that banks do not fully take into account relevant risk drivers, so focussing, for instance, only on the impact of transition risk rather than physical risk. Also the time horizons over which the risk could materialise into account are incomprehensive, while also the coverage of geographies and business lines falls short.

Strategy

The ECB demands that banks have a good understanding of the impact of C&E risks on their business environment, which should then be taken into account in strategic and business decisions. The blind spots mentioned above play a key role in this respect, given that many banks do monitor the impact of C&E risks on their business models, although they do this only partially or on a high level, excluding lower operating levels related to sectors, geographies, products and services. Indeed, 74% of banks have in place climate-related KPIs, but only 14% have a steering framework on a group level, and only 4% has such a framework on a portfolio level (see graph below left). Overall, this means that many banks do in practice have half-hearted policies in place to, for instance, take corrective action when KPIs are missed. This in turn, reduces the effectiveness of C&E related strategies or policies.

All in all, the ECB concludes that many banks still take a wait-and-see approach when it comes down to incorporating C&E risks into their strategies. Moreover, it is often unclear how banks effectively monitor these and how they want to achieve them. Finally, coverage of climate-related KPIs often falls short when compared to a bank’s exposures, business model and risk profile.

Governance of C&E risks

The report continues by assessing governance structures related to C&E risks. The ECB concludes that this has improved overall, with banks specifically becoming aware of data gaps. However, governance is still in the early stages of addressing climate risk in a ‘granular, bank-wide and comprehensive manner’. Almost all banks have dedicated C&E related committees, but most banks fall short in integrating C&E policies in their third line of defence, implying that no independent internal reviews on management of C&E risks are executed. Meanwhile, good data plays a crucial role in assessing and managing climate-related risks, but many banks have not yet in place a systematic way of data collection. Only15% of banks have in place such systems, collecting granular data on, for instance, energy performance certificates (EPC labels) for mortgages and the split between revenues stemming from green or polluting lending. Having said that, banks rely heavily on data from the companies and households they lend to, which is often not available.

Roughly 25% of institutions use advanced or forward looking quantification methods to measure risks stemming from climate change. This data is a crucial input to correctly measure the actual level of C&E risks. Meanwhile , 75% of banks have integrated climate-related issues into their capital adequacy assessments, although this is often based on qualitative judgements. Regarding credit risk, 25% of respondents had fully integrated C&E risks into the lending process, although most banks have incorporated some climate-related issues into their credit channel (but often not in a structural way). Meanwhile, almost all banks have in place measures to limit operational risk from climate change. This often refers to physical risks. Finally, the report shows that banks are increasingly taking into account other environmental risks, stemming from pollution, water stress, and biodiversity losses. Mostly, they use similar methods as those used to assess climate-related risks.

This article is part of the SustainaWeekly of 7 November 2022