According to the European Central Bank (ECB), most financial institutions do not have the tools to assess the impact of climate and environmental risks on their balance sheet. However, available estimates put the potential costs of physical and transition risks at the hundreds of billions of euros. The Financial Stability Board (FSB) finds that the manifestation of these risks, particularly where prompted by a self-reinforcing acceleration in climate change, could lead to a sharp fall in asset prices, an increase in uncertainty and a destabilising effect on the financial system, including in the short term. Risks could be concentrated in certain economic and geographic sectors, whilst also affecting economies at a national level.
It therefore comes as no surprise that, pandemic notwithstanding, this topic has been a top priority for international regulatory bodies in 2020. The ECB has recently published a non-binding guide on climate and environmental risks for banks, applicable to institutions directly supervised by the ECB (see our post on the initial consultation). The European Banking Authority (EBA) has published a consultation on the management and supervision of ESG risks, applicable to credit institutions and investment firms. Finally, the FSB has published a report on the potential implications of climate change for financial stability, which considers the financial system as a whole.
This blog post summarises the risks and possible regulatory interventions that are highlighted by these three international bodies.
What are the risks?
The following are common examples of climate and environmental risks flagged by the regulators.
- Extreme weather events may damage property, branches of financial institutions or their data centres, disrupt supply chains, and damage resources that are key to health and living conditions. The operations of financial institutions could be severely disrupted.
- Rates of borrower default and investment losses could increase through exposure to sectors or geographies that are vulnerable to physical risks. The assets of financial institutions and their counterparties, and the collateral used in lending, could be destroyed or devalued by wildfires or flooding for example. Lending may become more expensive, with knock-on effects for the wider economy.
- Assets could be devalued as a result of the transition away from technology and resources that are perceived to be carbon-intensive, such as coal mines, gas power plants, and oil reserves. These stranded assets would lose value even without exposure to physical risks.
- Abrupt repricing of securities, for example due to broad reallocation of capital by asset managers in order to address sustainability risks, may reduce the value of banks’ high-quality liquid assets, affecting liquidity buffers and reducing the resilience of the financial system.
- Firms may suffer reputational damage from being associated with adverse environmental impacts in the eyes of the public, commercial counterparties or investors. It is expected that revenues could be significantly affected if financial institutions, or even their counterparties, fall out of favour with the public on increasingly important sustainability issues.
- Public policy changes, particularly if abrupt or unforeseen, could significantly affect operating costs. For example, energy efficiency standards could require substantial adaptation efforts, affecting profitability and asset valuations.
- The exposure of institutions or their counterparties to climate change litigation is seen as an increasing risk, as discussed in our previous blog post.
What might the regulators do?
In the first place, regulators are requiring firms to identify and disclose their risks (see previous blog posts here and here). Beyond these initiatives, the FSB noted the following trends among financial authorities:
- they are starting to assess the management of climate and environmental risks by market participants and encourage mitigation, including preparing supervisory guidance;
- they are considering risks in financial stability monitoring and starting to quantify the risks through stress tests; and
- some authorities support mitigation of climate risks through macroprudential policies, which may be used to build resilience. This could, for example, be achieved through placing maximum credit ceilings or minimum credit floors on the concentration of certain activities to limit financial institutions’ exposure to sectors facing the greatest climate or environmental risks. Firms could be required to ensure that a minimum percentage of lending is allocated to “green” investments.
The EBA’s recommendation is that ESG issues should form part of the supervisory review carried out by supervisors under the EU’s Capital Requirements Directive and Investment Firm Directive. Supervisors should assess firms’ incorporation of ESG risks in strategies, governance and institutional controls, including risk appetite. Good practice in these areas and common definitions for identifying risks could be the subject of dedicated EBA guidelines, which may be implemented following the EBA’s consultation.
The ECB’s guide is aimed at senior managers and sets out the ECB’s views on the sound, effective and comprehensive management and disclosure of climate and environmental risks. The ECB will aim to use the guide in the supervisory dialogue with the credit institutions directly supervised by the ECB.
So, following the lead of the Bank of England which has been sounding the alarm for some time, international bodies are calling for better management of climate and environmental risks. Financial institutions can expect 2021 to be a year in which they come under pressure to take meaningful action.