Road to CRD 6 – ESG takes center stage in financial regulation

The ICAAP plays a key role in the risk management of banks. It is a bank’s own assessment of its capital needs. ICAAP can bridge deficits from the quantitative own funds regulation by ensuring that banks can cover all material risks at all times with a sufficiently large risk coverage potential of high quality.

While ESG risks were previously not explicitly included in the ECB and European Banking Authority (EBA) guidance on ICAAP, the ECB has already made its expectation clear that banks should also consider ESG risks in their internal capital allocation. CRD 6 will now require banks to explicitly take into account the short, medium and long term for the coverage of ESG risks in their strategies and processes to assess and maintain on an ongoing basis the amounts, types and distribution of internal capital. Banks’ internal capital allocation to address ESG risks is, thus, considered to be key to strengthening resilience to the negative impacts of these risks.

Robust governance arrangements are key to ensuring the sound management of risks. The CRD 6 will focus on integrating ESG risk into the banks’ governance arrangements, in particular their risk management and remuneration policies and practices, as well as their strategies and policies – emphasizing the specific short, medium and long-term time horizons that an adequate consideration of ESG risks requires.

The major novelty of CRD 6 is the introduction of an additional requirement to draw up and implement specific plans, quantifiable targets and processes to monitor and address the financial risks arising from ESG factors in the short, medium and long term, including those arising from the transition towards the relevant Member States and EU regulatory objectives and legal acts in relation to ESG factors in particular those set out in the European Climate Law, as well as, where relevant, third country objectives and regulations (Transition Plans, Targets and Processes). To this end, banks are particularly called upon to assess the alignment of their portfolios with the ambition of the EU to become climate-neutral by 2050 as well as avert environmental degradation and biodiversity loss.  

The targets and measures to address the ESG risks included in these Transition Plans, Targets and Processes shall consider the latest reports and measures prescribed by the European Scientific Advisory Board on Climate Change and shall be consistent with sustainability commitments as reported under the CSRD. Details on the content will be defined by the EBA in specific guidelines.

The principle of proportionality is emphasised along these lines. This initially suggests that smaller banks might benefit from reduced requirements. However, the size of the bank and its ESG risk exposure are not necessarily correlated.

Policies and procedures are the backbone of a bank. They standardise processes and ensure a consistent treatment of risks. It does not come as surprise, then, that CRD 6 will provide for specific requirements for strategies, policies, processes and systems regarding ESG risks, taking into account their specificities such as their forward-looking nature and their distinctive impacts over short, medium and long-term time horizons. 

Supervisory authorities had previously made it clear that ESG risks must be included in strategies, principles, and systems for ESG risk management and that this will also be reflected in ongoing supervision. What is new, however, is the level of detail and the resulting mandatory nature that CRD 6 introduces with a dedicated Article.

Competent authorities are particularly tasked with assessing the robustness of the Transition Plans, Targets and Processes outlined above. In doing so, special emphasis shall be placed on the banks' sustainability-related product offering, their transition finance policies, related loan origination policies, and ESG-related targets and limits. 

A key focus of CRD 6 is the fitness and propriety of board members and key function holders. As already foreseen in the ECB’s fit and proper guide as well as EBA’s and ESMA’s guidelines, CRD 6 will now also stipulate that the management body of a bank shall possess collective knowledge, skills and experience to be able to adequately understand the ESG factors relevant to the individual bank and its portfolio in the short, medium and long term. In addition, entities should be required to devote adequate human and financial resources to the induction and training of members of the management body on ESG Factors. The interesting point here is that the draft explicitly refers not only to ESG risks, as it generally does, but also to impacts, which ties in with an understanding of double materiality as known from the Corporate Sustainability Reporting Directive (CSRD).

In the course of the SREP, supervisors assess the risks a bank faces by reviewing the bank’s business model, its governance and risk management, the risks to the bank’s capital and its liquidity and funding. The outcome of the assessment is a SREP score, which determines whether and to what extent additional supervisory measures, such as a capital add-on, will be taken. 

All of these four cornerstones of the SREP had already taken into account ESG risks to some extent. This had already been formally clarified by the EBA in its SREP guidelines for certain aspects and has become part of the supervisory practice of the ECB and national supervisory authorities. In the 2023 SREP cycle, 12% of significant institutions received additional SREP measures, highlighting the need to remediate climate- and environmental-risk related deficiencies and address new findings. And the supervisory authorities have made one thing increasingly clear in recent years: the expectations placed on banks when dealing with ESG risks are continually increasing.

The CRD 6 amendments will now highlight the particular emphasis that supervisory authorities shall place on banks’ exposures to ESG-risks in the SREP. The long-term nature and the profoundness of the transition towards a sustainable, climate-neutral and circular economy will, for example, entail significant changes in the business models of banks, which have to be assessed in the SREP.

In this context, a particular focus will also be placed on bank’s Transition Plans, Targets and Processes. These are to be specifically reviewed by the supervisory authorities, along with the progress made towards addressing the ESG risks arising from the process of adjustment towards climate neutrality by 2050. 

The forward-looking nature of ESG risks means that scenario analysis and stress testing are particularly informative tools for exploring the future impacts of climate risks. This pertains not only to centralised stress tests by supervisory authorities, such as the ECB's 2022 climate stress testing exercise, but also to internal stress tests conducted by the banks. 

ESG risks are not yet included in EBA’s guidelines on institutions’ stress testing and so far, methodologies for ESG risks have mainly been applied in an exploratory manner. CRD 6 now calls on the European Supervisory Authorities (ESAs) to jointly develop guidelines to ensure consistent and long-term ESG stress testing, based on available scientific evidence and building on the work of the Network for Greening the Financial System and the previous efforts by the Commission. 

Stress testing of ESG risks should start with climate and environment-related factors, in particular climate related risks and risks stemming from environmental degradation and biodiversity loss, in light of their urgency. As more ESG risk data and methodologies become available, competent authorities should increasingly assess the impact of those risks in their adequacy assessments of banks.

While, so far, Transition Plans, Targets and Processes have been neither mandatory nor enforceable, CRD 6 proposes wide-ranging powers for the supervisory authorities. Article 104 CRD 6 shall allow them, in particular, to request banks to reduce their ESG-risks through adjustments to their business strategies, governance arrangements and risk management processes as well as a reinforcement of the targets, measures, and actions included in their Transition Plans, Targets and Processes outlined above.

The systemic risk-buffer is a capital add-on consisting of CET 1 capital that a supervisory authority can apply to banks under its supervision to account for systemic risks. The CRD 6 will now unsurprisingly clarify that  climate change may constitute a systemic risk. In this regard, it is noteworthy that the respective provision in CRD 6 – unlike the other amendments – only refers to risks arising from climate change, not ESG-risks in the broader sense, which emphasises that the regulatory state of play in this respect is still more advanced than for the other aspects.

Systemic risk buffers were already highlighted by the EBA in their report on the role of E&S-risks in the prudential framework as a particularly useful and flexible instrument to account for ESG-risks. The competent authorities could apply them to certain sets or subsets of exposures, for instance, for those subject to physical and transition risks related to climate change, where they consider the introduction of such a rate effective and proportionate to mitigate those.