Banks must enhance their climate and environmental risk management frameworks

Contribution by Edouard Fernandez-Bollo, Member of the Supervisory Board of the European Central Bank, for Eurofi Magazine

20 February 2024

Since the ECB started to develop a prudential supervisory approach to climate-related and environmental (C&E) risks in 2019, four years after the Paris Agreement, significant progress has been made. Back then, less than a quarter of banks under our supervision had reflected on how the climate and environmental crises affected their strategy. Now, the climate and environmental crises have made it to the top levels within banks and some important steps have been taken. But swifter action is needed, as C&E risks are increasing.

Banks acknowledged the materiality of the climate-related risks in their portfolios in 2022, with 70% seeing material risks within their business planning horizon of three to five years. Encouragingly, over 85% of banks have at least basic practices in place for most of the areas addressed by our supervisory expectations on C&E risks, which we published in 2020. This means that they have performed an initial mapping of their risk exposures, allocated responsibilities within the organisation, set initial key performance and risk indicators, and developed a qualitative mitigation strategy for at least part of their risk exposures.

However, the approaches are inadequate to meet the growing challenges ahead – they still lack methodological sophistication, the use of granular information on risk and/or active management of the portfolio and risk profile. As a result, more than half of the banks under the ECB’s supervision are not implementing the practices effectively. Furthermore, some institutions are still lagging behind and have not shown any material progress. We need to push banks to do more, not only from the purely supervisory perspective of ensuring that they are fully aligned with all expectations by the end of 2024, but also from the broader perspective of ensuring C&E risks are adequately identified and managed at a time when science is clearly telling us that the underlying risk factors will only increase. This is why C&E risks continue to be classified as significant and increasing on the SSM Risk Map: there is an increasing likelihood of a disorderly transition materially affecting carbon-intensive sectors, posing challenges for banks and the economy as a whole.

Our recent analysis of banks covering 75% of euro area loans^[1] shows that currently banks’ credit portfolios are substantially misaligned with the goals of the Paris Agreement, leading to elevated transition risks for roughly 90% of these banks. The analysis shows that transition risks largely stem from exposures to companies in the energy sector that are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production. Therefore, banks need to draw up plans to address C&E risks arising from the process of adjustment towards climate neutrality by 2050, which will become a requirement under the revised Capital Requirements Directive (CRD VI). To that end, banks should gather relevant information from their clients and update their risk appetite accordingly. The plans should include concrete intermediate milestones from now until 2050 and develop key performance indicators that allow their management bodies to monitor and act upon any risks arising from possible misalignment with their transition path.

Clearly, this will require significant effort and entail upfront costs. But analysis consistently shows that the benefits of a timely transition far outweigh the costs^[2], especially when assessed against the alternative scenarios of doing nothing or doing too little too late. This is why we are ready to use all our supervisory tools to ensure that banks make this effort. And we are convinced that they can, as the good practices observed in numerous banks demonstrate how the sector can harness innovation to address the prevailing challenges. In 2022 leading practices were observed in 25 out of 30 areas under investigation, including in traditionally more challenging ones, such as data governance, risk classification and pricing. Since then, many banks have implemented good practices to measure and respond to C&E risks, including through client engagement and transition finance. We are therefore confident that a sustained effort can ensure progress towards full alignment with the expectations. Our goal is to encourage the broader adoption of these best practices, developed by the banks themselves, in order to increase the resilience of the financial system and the economy as a whole.