Banks need to be climate change proof

Blog post by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB

2 November 2022

The economy needs stable banks, especially as it goes through the green transition. As supervisors, our role is to ensure that banks remain prudentially sound, now and long into the future. For this to happen, banks must be able to identify, assess, control and mitigate the inevitable risks materialising from the climate and environmental crises. Although banks have started to do this, there is a long way to go before they are climate change proof. We will therefore continue to scale up our supervisory activities. We expect banks to be able to fully manage their climate-related and environmental risks by the end of 2024.

Today we have published the results of our thematic review on these risks. We have closely examined banks’ strategies, governance and risk management practices. Together with 21 national competent authorities, we assessed 186 banks holding total assets of €25 trillion and took further actions to create the most comprehensive picture of how banks have been dealing with these risks.

The glass is not even half full

Simply put, the glass is filling up slowly but it is not yet even half full. Yes, climate change has made it to the top levels within banks and some first steps have been taken. But there is a difference between talking about steps and beginning to act; and there is an even bigger difference in doing what is needed. Here are three examples of shortcomings in risk identification, strategy and living up to commitments.

First, we detected blind spots at 96% of banks in their identification of climate-related and environmental risks in terms of key sectors, regions and risk drivers. Where banks do assess the risks, they are not yet able to grasp the full magnitude as most do not actively collect granular counterparty and asset-level data. And almost all boards are still unaware of how these risks will develop over time, what precise risk level the bank can accept and what action it will take to rein in excessive risk.

Second, most banks’ strategy documents are full of references to climate change, but actual shifts in revenue sources remain rare. Banks are certainly keen on new forms of sustainable business, and have plans to allocate more funds to them soon. Many are also phasing out specific activities, such as thermal coal power generation, and have started discussing the transition with their most carbon-intensive clients. However, it is too often still unclear how these initial steps shelter banks’ business models from the consequences of climate change and environmental degradation in the years to come. For instance, some banks have committed to reaching net-zero emissions by 2050 but fail to define “net zero” and fail to set interim targets. Such targets would allow banks to actively steer towards their commitments. That would bring them closer to reaching their goals on time.

Most banks have thus not yet answered the question of what they will do with clients who may no longer have sustainable revenue sources because of the green transition. In other words, too many banks are still hoping for the best while not preparing for the worst.

Third, more than half of banks have put policy frameworks in place or have made green commitments but have not put them into action. For instance, some banks have policies explaining how to deal with clients engaged in risky activities. However, when assessing real cases, we see that clients – even notorious polluters – have sometimes been exempted from these policies. We also find that certain banks have ignored clear warnings from their own specialists. These banks risk serious repercussions on their balance sheets, particularly where they publicly make “green” claims.

But the glass is slowly filling up

But as I said, the glass is no longer empty and things are getting better. Several good practices have been identified, demonstrating that swift progress is possible. Here are three examples of good practices.

Starting with strategy, we have seen that some banks are already using transition planning tools. This involves using scientific pathways to assess the alignment of their portfolios with the Paris Agreement. These pathways set concrete intermediate targets showing how portfolios must evolve over time to meet longer-term objectives. One of these objectives is reaching net-zero emissions by 2050. The banks take actions when individual clients are not on track to meet the objectives set and address cases where engagement fails. Ultimately, such action can include abandoning client relationships.

Second, we have observed banks that map out data needs for their disclosures, risk management, business objectives and commitments. They collect data from a variety of internal and external sources. The banks tend to favour actual client data, which they collect from a broad customer base via questionnaires. And these banks do not take no for an answer. Instead, they experiment with ways of encouraging customers to fill in the questionnaires. When acquiring data from third-party providers, the banks assess the methodologies used and the quality of the data supplied. In taking this approach, banks ultimately aim to report granular risk indicators to their board, providing a forward-looking view on risk exposures.

Finally, when assessing capital needs, some banks take into account forward-looking climate and environmental factors over a longer time horizon. These assessments cover both physical and transition risks. Frontrunners have even put aside capital specifically to manage material climate-related risks based on the outcome of their capital adequacy assessments.

Some banks are ahead of the pack

So, we see groups of banks leading the way and showing that swift progress is possible. And they are from all “walks of life”: big and small, local and international, specialised and universal, and from a variety of jurisdictions. But time is of the essence. That is why we have given each bank clear timelines. We expect that by the end of 2024 they will be fully aligned with all of our supervisory expectations on these risks.^[1] There can be no more questions about responsibilities. Banks must have risks fully measured and priced. Boards need to have set their banks on an unequivocal course to longstanding resilience. In doing so, banks should not limit themselves to reaping the fruits of a greening economy and addressing transition risks. They must also respond to the physical impacts of climate change. Moreover, they must properly handle the risks related to biodiversity loss and broader environmental risk.

We have also told banks the supervisory consequences they face if they fail to meet their climate responsibilities. Deadlines will be closely monitored and, if necessary, enforcement action will be taken.

Laggards need to catch up quickly

Banks need to adjust before it is too late. They must look further into the future and take the necessary actions now to fill the glass. It takes time to fundamentally adapt and design concrete pathways to maintain a resilient business model. These efforts will make each bank and our financial system more resilient and better equipped for an economy that faces the climate and environmental crises while also working through the green transition.