Room for improvement for European banks to meet supervisor’s expectations on environmental and climate risks

The loss and deterioration of nature and climate change affect the functioning of our economy. Its effects cause structural changes that have an impact on economic activity and, in turn, on the financial system. In general, climate- and nature-related risks are considered to comprise two main risk factors:

• Physical risk: refers to the financial impact of a changing climate and the loss and deterioration of biodiversity and ecosystems.
• Transition risk: financial losses that an institution may suffer as a result of adjusting to a lower-carbon and environmentally sustainable economy.

These risks have an impact on macroeconomic indicators such as inflation, economic growth, financial stability and monetary policy transmission, as well as on the value and risk profile of assets on the Eurosystem’s balance sheet. For this reason, banking regulators and supervisors are making significant efforts to take into account the influence of environmental and climate aspects to maintain financial and price stability. This involves incorporating considerations related to nature and climate change into analyses and decision-making processes; macroeconomic models, projections and scenarios; financial stability assessments; risk management frameworks and investment portfolios.

ECB RISK EXPECTATIONS CLIMATE AND ENVIRONMENTAL

Among the measures implemented by the European Central Bank to manage environmental and climate risks is to ensure that banks also manage them and apply a safe and prudent approach in their identification, assessment and management, as well as to transparently report on their exposure to them.

In this regard, the European Central Bank (ECB) published at the end of 2020 the Guide on climate-related and environmental risks. Supervisory expectations for risk management and communication, in order to ensure that the banking sector effectively and comprehensively addresses these risks.

At the beginning of 2021, financial institutions were asked to conduct a self-assessment of their current practices in relation to the expectations set out in the guidance and to report to the ECB on their implementation plans to advance environmental and climate risk management. The results of the self-assessment were published in the Walking the talk report (November 2022), together with the deadlines within which banks should meet the expectations set out in the ECB’s guidance on climate and environmental risks:

• By the end of 2023 at the latest, the ECB expects banks to include climate and environmental risks in their governance, strategy and risk management; and
• by the end of 2024, banks will need to meet all other supervisory expectations on climate and environmental risks made in 2020, including a robust integration of environmental and climate risks into their stress testing framework and internal capital adequacy assessment (ICAAP) processes.

STRESS TESTS

This review was carried out in parallel with the first supervisory stress test on climate-related risks, in which banks’ stress test frameworks were assessed, including from a qualitative perspective (Expectation 11) of banking institutions. The review was carried out by the ECB and 21 national competent authorities and covered 107 significant institutions and 79 less significant institutions.

The results were published in July 2022 and showed that, despite significant progress by banks, they still do not meet the ECB’s expectations on incorporating climate risk into their respective stress testing frameworks and internal models. The test identified multiple deficiencies, data gaps, and inconsistencies across the various entities. These include that 60% of the banks in the sample do not yet have a well-integrated climate risk stress testing framework in place, or that the independence between the development and internal audit function is not yet actively involved in the review of the frameworks in 40% of banks.

BEST PRACTICES: CHANGE IS POSSIBLE

In order to demonstrate that rapid progress is possible and to facilitate improved practices among financial sector actors, the ECB published in November 2022 a compendium of good practices observed in some banks.

Some of the examples of good practice show how banks are already using transition planning tools, which involves using scientific pathways to assess the alignment of their portfolios with the Paris Agreement.

Other financial institutions define data needs for their disclosures, risk management, business objectives, and commitments. They collect data from various internal and external sources and tend to favor actual customer data , which they collect from a broad customer base through questionnaires. When acquiring data from external providers, banks evaluate the methodologies used and the quality of the data provided

Finally, when assessing capital needs, some banks take into account forward-looking climate and environmental factors over a longer time horizon. These assessments cover both physical and transition risks. The most advanced banks have even set aside capital specifically to manage significant climate-related risks based on the results of their capital adequacy assessments.

ROOM FOR IMPROVEMENT FOR TRANSPARENCY AND COMPLIANCE WITH SUPERVISORY STANDARDS

In April this year, the ECB published its third assessment of the progress made by European banks in disclosing environmental and climate risks (the second analysis dates from 2022 and the first was published in 2020). Although banks have increased the information they publish in the past year, the quality of their disclosures is still too low to comply with upcoming supervisory standards. In general, Europe’s largest banks publish better information than their non-EU counterparts, but they do not fully meet the ECB’s expectations.

European banks must prepare to comply with the EU’s stricter rules on climate and environmental risk disclosures that come into force this year. The implementation of the Pillar 3 Reporting Implementing Technical Standards (NTE), a set of environmental, social and governance (ESG) risk reporting standards issued by the European Banking Authority (EBA), will apply to most major banks in the euro area. Eligible banks have to submit their first information under the new rules by the end of June 2023.

The NTEs establish the requirements for ESG disclosures by financial institutions, with the aim of providing investors and other stakeholders with a more complete and reliable picture of the ESG performance of financial institutions. They focus on establishing minimum requirements for external disclosure of ESG information, are issued by national regulators or regulatory entities for ESG disclosure, but their compliance may vary depending on the jurisdiction and the specific financial institution. Non-compliance with NTTs may have implications in terms of transparency and investor confidence, but does not necessarily have direct regulatory consequences.

Regarding the results of the third evaluation, compared to the second analysis, banks have significantly increased the amount of basic information they publish by category. For example:

• The percentage of significant banks disclosing significant exposures to climate and environmental risks increased from 36% to 86%.
• Almost all banks now declare how their respective boards oversee climate and environmental risks.
• More than 9% provide basic descriptions of how they identify, assess, and manage these risks.
• However, the quality of the information disclosed is often inadequate. Of the major banks that participated in the exercise, only 6% disclose information that is at least broadly adequate in all five categories of the assessment.
• While 50% of banks now provide information on the amount of issues they finance, in the vast majority of cases this information is incomplete, unspecific or not properly justified. As a result, banks appear to be unprepared for the EBA’s looming Pillar 3 disclosure rules.

The ECB has also compared for the first time the climate and environmental risk information of the largest EU-based banks (global systemically important banks or G-SIBs) with that of their non-EU counterparts. The evaluation shows that although EU-based G-SIBs are not yet fully in line with supervisors’ expectations, they generally outperform their global counterparts in all assessment categories.

NEXT STEPS

Supervisors have informed banks of their findings, asking them to address the shortcomings and submit plans on how they will prepare to comply with the EBA’s imminent reporting standards. The ECB’s assessment report includes multiple examples of good practices that banks can take into account in their efforts to align information with supervisors’ expectations. Throughout the second half of 2023, the ECB will examine whether the admitted banks comply with the new rules. Failure to comply will constitute a breach of the Capital Requirements Regulation (CRR) and will lead to supervisory action.