The European Central Bank (ECB) is consulting on a proposed supervisory guide on managing and disclosing climate-related and environmental risks. It joins the growing number of regulators seeking to address the management and disclosure of climate and environmental risks in the financial services sector. This blog post explores the ECB’s draft guide.
The guide is aimed at significant eurozone banks directly supervised by the ECB, but is also intended to form a basis for national regulators’ supervision of less significant banks in their jurisdiction. It was prepared with input from national regulators and is consistent with the supervisory expectations that the PRA has published in the UK. Whilst the extent to which the guide will be persuasive in the UK after the Brexit transition period remains to be seen, many international banks operating in the UK will need to take it into account in respect of their eurozone operations.
What are climate-related and environmental risks?
The guide focuses on climate-related and environmental risks to banks. The ECB adopts the common risk categorisation of ‘physical’ risks (physical impacts of a changing climate and environmental degradation), and ‘transition’ risks (risks arising from the shift towards a lower-carbon and more sustainable economy). The ECB also refers to ‘liability’ risks, such as the climate change litigation risks discussed in our previous blog.
These risks could materialise in various ways, including substantial devaluation of assets, changing customer attitudes, or expensive unforeseen liabilities. Regulators increasingly consider them to be capable of affecting financial stability.
The guide contains 13 supervisory expectations which clarify the ECB’s understanding of the safe and prudent management of climate-related and environmental risks under the current prudential framework (the Capital Requirements Regulation, Capital Requirements Directive and European Banking Authority Guidelines). The expectations cover long-term strategic decision-making, management responsibilities, credit granting processes, business continuity, and risk disclosure, among others. For example, banks are expected to allocate express responsibility for managing climate and environmental risks to members of the board or a dedicated sub-committee. Management is expected to review policies and procedures addressing climate and environmental risks on a regular basis.
Echoing the Bank of England’s stress-testing initiative, the ECB includes an expectation that banks facing material climate-related risks evaluate their internal stress testing, with a view to incorporating those risks in their baseline and adverse scenario tests. The ECB considers climate and environmental risk to be relevant to existing stress-testing requirements under the Capital Requirements Directive.
Consequences for banks and their customers
One of the most commonly cited challenges of managing climate, environmental and other sustainability risks is the lack of tools, data and expertise. For example, the ECB expects banks to assess and manage the risks of ‘droughts or floods affecting regional agricultural production or housing demand’, or ‘Policy changes to promote an environmentally-resilient economy [which] may reduce the demand for real estate in certain, for example high flood risk, areas’. The ECB acknowledges the practical difficulties, but states that ‘risks are not expected to be excluded from the assessment because they are difficult to quantify or because the relevant data are not available’.
In the short term, therefore, demand for ESG expertise seems likely to continue going up, while the availability of mortgages for homes on the coast or in a flood plain may be about to go down.
In the longer term, the ECB and other regulators hope that adjustments to governance and risk management frameworks will guide banks and their customers towards sustainable economic activity that avoids the climate and environmental risks identified in the guide.
The ECB has invited comments from industry and other stakeholders, and released a list of FAQs. The consultation period ends on 25 September 2020. The guide will apply on publication of the final version.
"most of the institutions do not have the tools to assess the impact of climate-related and environmental risks on their balance sheet" (ECB supervisory guide)