Eurozone banks told to do more to tackle climate change risks

When the ECB announced its Guide on climate-related and environmental risks in November 2020 together with 13 supervisory expectations on the management of such risks, it was far from clear how much effort the ECB would actually put into enforcing these expectations. Now, almost exactly one year later, on 22 November 2021, and after a thorough self-assessment conducted by 112 significant institutions, the ECB has published its final report The state of climate and environmental risk management in the banking sector. In this report, the ECB comprehensively assesses the state of climate-related and environmental (C&E) risk management in the banking sector.

The ECB has found that none of the institutions is close to fully aligning its practices with the supervisory expectations and only some of them have taken significant steps towards adapting their practices to reflect C&E risks. Most institutions will also not be aligned with supervisory expectations in the near future. This result is alarming, since those institutions which have assessed the materiality of C&E risks have found that C&E risks will have a material impact on their risk profile in the coming three to five years.

The report sets out a granular picture of the extent to which institutions are complying with each supervisory expectation. The ECB notes that little progress has been made in the areas of internal reporting, market and liquidity risk management, and stress testing. The lack of adequate internal reporting may even contradict other efforts. While almost 50 per cent of all institutions have assigned responsibility for managing C&E risks to a management body, this management body is often not provided with the required internal reports to discharge its responsibility.

Climate-related and environmental risk management

The ECB also found that integration of C&E risks into risk management strongly depends upon the type of impacted risks. Practices related to credit risk, which is deemed by institutions to be most impacted by C&E risks, have been adapted by approximately two-thirds of the institutions.

However, the risk management of transition risks is often more developed than for physical risks. For instance, only a few institutions are taking into account the geographical location of their real estate collateral, although this should give insight into physical risks that the collateral is exposed to (eg floods). Environmental risks beyond climate-related risks such as biodiversity loss and pollution are often a blind spot in risk management. The integration of C&E risks into the market and liquidity framework is, however, far less developed compared to credit risk.

After a supervisory dialogue with each institution was conducted by Joint Supervisory Teams between August and September 2021, the ECB sent individual feedback letters to the banks, calling them on to address the shortcomings, including an overview of peer benchmarking. For some institutions, a qualitative requirement has been communicated as part of the 2021 Supervisory Review and Evaluation Process (SREP). The ECB is committed to continuing its supervisory dialogue with banks and will gradually integrate C&E risks into its SREP methodology, which will eventually influence Pillar 2 capital requirements.

In the first half of 2022, the ECB will request institutions to perform a Climate Risk Stress Test (CST) (incl. methodology). At the same time, the ECB will conduct a full review of how prepared banks are to manage C&E risks, with deep dives into their incorporation into strategy, governance and risk management. Moreover, supervisory teams are currently investigating banks’ C&E risk disclosures. The ECB will publish its findings in an updated report on climate and environmental disclosures together with individual feedback to the banks in the first quarter of 2022.

At the legislative level, banks' C&E risk management will be further fostered. In its recent proposal for CRD6, the European Commission puts an emphasis on the strengthening of C&E risk management requirements.  Banks will be required to include short-, medium- and long-term horizons of ESG risks in their strategies and processes for evaluating internal capital needs, as well as adequate internal governance. Eventually, the EBA SREP Guidelines will be amended to integrate, amongst other things, the relevance for ESG risks for the SREP process and EBA Guidelines on the management and supervision of ESG risks will be adopted.

The integration of ESG risks into the banks' risk management and their long-term strategy-setting and, closely linked, into their business models and business plans will be a key challenge in years to come. The report leaves no doubt that the ECB is committed to closely monitoring banks’ efforts and progress. And the ECB's message in the report is clear: the time for action is now.