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Elizabeth McCaul
Board Member
  • CONTRIBUTION

Operationalising climate-related and environmental risk management

Contribution by Elizabeth McCaul, Member of the Supervisory Board of the ECB, for Eurofi Magazine

10 September 2024

Five years ago, less than a quarter of the banks under our supervision had incorporated climate-related and environmental (C&E) risk in their risk management frameworks. We have come a long way since then. Most banks have now drawn up materiality assessments that are aligned with our supervisory expectations. But this is only a first step, and much more work lies ahead.

Banks continue to face challenges in operationalising C&E risk management and ensuring comprehensive coverage of all C&E risk categories. This especially concerns integrating physical risks alongside transition risks and applying forward-looking data.

C&E risk, by its nature, is a forward-looking risk characterised by uncertainty. This uncertainty stems not only from the physical impacts of climate change but also from policy changes in the transition towards a decarbonised economy.

To navigate this uncertainty, banks need robust tools and methodologies. One effective approach is what is known as an alignment assessment. This measures transition risks by comparing the projected production volumes in key economic sectors with the required rate of change to meet given climate goals. This method allows banks to anticipate and prepare for potential changes, which makes it the best available tool for forward-looking risk assessment.

Banks have started to deploy alignment assessments broadly, incorporating various good practices to enhance their effectiveness. In early 2024, we published a report entitled Risks from misalignment of banks’ financing with the EU climate objectives that outlines some of the best practices. These include:

  • Selection of representative scenarios: The scenarios should be science-based and consistent with stated policy objectives such as those formulated in the Paris Agreement.
  • Consistency of choice: Scenario choices used for strategic planning, risk management and disclosures should be internally consistent and well documented.
  • Re-baselining: The scenario should be up to date, and the choice of base year should be well justified. If an analysis is updated, the base year of the decarbonisation pathway should be aligned with the year of the analysis.
  • Geographical relevance: The scenario should be geographically relevant to the portfolio under consideration.
  • Annual updates: The scenarios should be updated on an annual basis to incorporate global events, changes in the carbon budget and technological developments.

Despite these efforts, misalignment can still occur. The ECB’s report on good practices for climate-related and environmental risk management sets out ways that banks can effectively deal with the risks of such misalignment.

Transition planning should become a cornerstone of standard risk management, linking banks’ assessment of material transition risk drivers, strategic targets, risk appetite frameworks, risk management tools and the wider organisational set-up. For example, some banks have started managing transition risks by introducing active client engagement and offering transition finance products. Banks can enter a structured dialogue with their clients to steer them towards a trajectory that is aligned with the envisaged portfolio pathways. There are also synergies in the parallel management of transition and physical risks at client level, which could also be leveraged by means of sustainable financing products. These examples show that progress is possible.

At the same time, we acknowledge that challenges related to data and methodologies persist. The ECB has publicly supported policies to improve data availability for the purposes of C&E risk management.

For example, our opinion on the revised Energy Performance of Buildings Directive (EPBD) expresses our support for the aim of the EPBD to improve access to energy performance certificates and stresses the need for credit institutions to have access to that information. We also called for harmonised methodologies across the EU to foster comparability and reliability.

Another example is the proposed ESG Rating Regulation. Our opinion highlights that increased transparency together with increased reliability and comparability thanks to comprehensive disclosure standards will help facilitate the use of ESG ratings as an input factor in banks’ monitoring processes.

2024 is a pivotal year for banks to become more resilient to C&E risks. By the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C&E risks. This requires ongoing refinement of materiality assessments, integration into business strategies and rigorous risk management practices. ECB Banking Supervision will continue to push banks and thereby to ensure that the banking system remains safe and sound as we transition to a net-zero world.

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