ECB turns up the heat on banks to tackle climate risks (Part 1)

This is the first part of a two-part series on the ECB's efforts to address climate-related and environmental risks (C&E risks) in the banking sector. 

It has become clear in recent years that addressing C&E risks is no longer optional for Eurozone banks but has become and will continue to be one of the ECB’s Supervisory Priorities 2023 to 2025.

The ECB is stepping up its efforts to address C&E risks in the banking sector placing increasing pressure on banks through a series of measures and what it calls a ‘mutual learning process.’ The ECB vigorously pursues the implementation of its priorities and expectations – despite the lack of specific legal requirements, which will only become effective once the Capital Requirements 6 Directive (CRD6) is in force. Prior enforcement is possible as C&E risks are not seen as a separate category of risk but rather as ‘drivers of existing categories of risk,’ which must be prudently managed under current prudential rules.

How supervisory expectations translate into qualitative and quantitative SREP requirements

In November 2020, the ECB published a guide on C&E risks with a set of non-binding expectations, setting the stage for further action. In early 2021, the ECB asked banks to conduct self-assessments in light of the supervisory expectations outlined in the guide and to draw up implementation plans on that basis. The ECB responded to the self-assessments with individual feedback letters in September 2021, imposing qualitative requirements on some banks as part of the 2021 Supervisory Review and Evaluation Process (SREP). In November 2021, the ECB found in its report on the supervisory review of banks’ approaches to managing C&E risks that none of the institutions were close to fully aligning their practices with the supervisory expectations and that the pace of progress overall remained too slow.

In response, the ECB continued its efforts in early 2022 by sending out questionnaires to banks and requesting updates of their implementation plans. It also launched a thematic review, conducting deep dives into banks’ C&E risk strategies, as well as their governance and risk management frameworks and processes (excluding stress testing, which was covered by a separate exercise, the 2022 thematic stress test). Subsequently, banks were sent individual comprehensive feedback letters, in which the ECB set institution-specific remediation timelines for identified shortcomings. In the 2022 SREP, the ECB imposed binding qualitative requirements on more than 30 banks to address severe weaknesses (one example given by the ECB is where institutions had not yet allocated responsibilities for C&E risks in its governance at all). For a small number of banks, the thematic review even had an impact on their SREP scores, ie what started in November 2020 with non-binding expectations resulted in higher Pillar 2 capital requirements less than two years later.

The ECB's Final Report of the 2022 Thematic Review, which was published on 2 November 2022, found that ‘banks are still far from adequately managing climate and environmental risks.’ While individual and specific remediation timelines have been set for each institution, the ECB communicated its general expectation for banks to reach, as a minimum, the following milestones with a view to achieving full alignment with its expectations by the end of 2024:

1. By March 2023, the ECB expects banks to adequately categorise C&E risks and to conduct a full assessment of their impact on the bank’s activities.
2. By the end of 2023, the ECB expects banks to include C&E risks in their governance, strategy, and risk management.
3. By the end of 2024, the ECB expects banks to meet all remaining supervisory expectations, including full integration in the Internal Capital Adequacy Assessment process and stress testing.

The ECB leaves no doubt that it remains determined to enforce its expectations for the treatment of C&E risks and announced that relevant timelines and requirements would be closely monitored and, if necessary, enforced by the Joint Supervisory Teams and reflected in the C&E risk assessment of the SREP and its qualitative and quantitative requirements in 2023 and beyond.

In the next part of this series, we assess the results of the ECB’s 2022 Thematic Review and what the ECB considers a ‘good practice’ as well as current legislative initiatives to establish these practices in statutory law.