ECB Banking Supervision’s approach to climate risks

Keynote speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the European Central Bank Climate and Environmental Risks Webinar

Frankfurt am Main, 17 June 2020

The magnitude of climate-related risks for banks is likely to be significant

It is my pleasure to welcome you all to this first ECB webinar on climate and environmental risks. In addition to representatives of more than 100 euro area banks, we are joined by banking associations, the Network for Greening the Financial System (NGFS), the European Commission, the European Banking Authority (EBA), our Joint Supervisory Teams (JSTs) and colleagues from national competent authorities with whom we are working very closely as we roll out our approach to the supervision of these risks.

The coronavirus (COVID-19) pandemic has been a stark reminder of how truly uncertain the future is and that, sometimes, outcomes can be very severe. It has also reminded us – again – of the crucial importance of a resilient financial system. Thanks to the reforms put in place after the great financial crisis, this time banks have been able to absorb the immediate fallout from the shock rather than amplify it. This underscores the value of a well-capitalised banking system which is able to deal with a broad range of risks.

At times, however, we actually have a fairly good idea of what’s coming. We are aware that something is about to happen, but we might not be sure of the exact size of the potential impact. We are not dealing with fundamental uncertainty, but with risk. This seems to be the case for climate change. All of the available evidence shows that it is real, and it has consequences. But while we know that the challenge of climate change is a severe and potentially existential one, this knowledge also allows us to prepare. And prepare we must, the financial system included.

Although methodologies for estimating the magnitude of climate-related risks for banks are still being developed, available estimates suggest that the impact of these risks is likely to be significant. For example, our colleagues working on financial stability found that, on average, 15% of significant institutions’ exposures are to the most carbon-intensive firms. A recent assessment also confirms that an abrupt transition to a low-carbon economy would have a severe impact on climate-sensitive economic sectors, triggering an increase in banking system losses of up to 60% compared with a baseline scenario. A transition risk stress test in the Netherlands showed that the banking sector’s Common Equity Tier 1 (CET1) ratio could drop by over 4 percentage points in a severe but plausible transition scenario.

The nature of climate-related risks requires forward-looking supervision

In principle, one might think that this could actually make things easier for supervisors: if we know what might be coming, we can prepare for it in time. But this is where the double tragedy of climate change strikes. It is beset not only by the well-known “tragedy of the commons”, in other words the excessive use of the atmosphere due to fossil fuel emissions. It also suffers from what Mark Carney called the “tragedy of the horizon”. The effects of climate change unfold over a longer time horizon than the horizon usually taken into account by investors, banks and policymakers. This is indeed one of the lessons of the great financial crisis that has not been learnt. Banks tend to measure and manage risks within a fairly short time frame. Their internal models seldom look beyond the next 12 months or, at most, the current economic cycle. Regulatory requirements confirm and reinforce this short-sighted approach. Climate change provides us with an opportunity to rethink in order to broaden our horizons and combine short-term, business-as-usual risk management tools with mechanisms that allow us to better understand and manage risks driven by more structural, long-term changes in our economies.

The physical impacts of climate change and environmental degradation, as well as the transition to a low-carbon economy, will have wide-ranging effects on many sectors and regions. The recent wildfires in Australia, the severe flooding in Venice and, according to some scientists, even the greater likelihood of another pandemic like the one we are currently experiencing, are harbingers of the potential impact on our well-being and the economy. As lenders to the real economy, banks will see the risks reflected on their balance sheets. Although we don’t know exactly what level of transition and physical risks banks will face, we do know that they will face some combination of these risks and that the risks will, in all likelihood, worsen over time. In our view, it is therefore critical for banks to start developing their capacity to manage climate-related and environmental risks.

The adequate pricing of climate-related risks will contribute to a smoother transition to a low-carbon economy

After all, our mission is to ensure the safety and soundness of the banking sector now and in the future. What’s more, adequately representing climate risks in banks’ balance sheets is a prerequisite not only for the sector’s resilience, but also for the accurate pricing of these risks. And this, in turn, will contribute to an efficient and orderly transition to a low-carbon economy.

Our approach to the risks related to climate change and environmental degradation does not depart from our traditional prudential focus. In fact, it aims to help us fulfil our banking supervision mandate. Today’s event can be seen in the broader context of our drive here at the ECB to increase transparency towards the market. We strive to be as transparent as possible in terms of our thinking on key issues and how they affect our supervisory approach. What we want to safeguard is a resilient banking sector that prudently manages all risks, and this clearly includes climate-related and environmental risks. That’s why we have joined the 66 central banks and supervisory authorities of the NGFS in stating that climate-related risks are sources of financial risk and should be addressed as such by both banks and prudential supervisors.

To this end, on 20 May the ECB launched a public consultation on a draft guide on the management and disclosure of climate-related and environmental risks. I will explain why we published this guide, what it contains and where we go from here.

As I said earlier, identifying and assessing the risks faced by supervised banks is crucial for banking supervision to be conducted effectively. The number and impact of extreme weather events continue to increase rapidly, resulting in new challenges for corporates, households and financial institutions, including banks. Accordingly, we are taking steps to increase understanding of the impact of climate change from a financial perspective and to ensure that banks progressively embed these risks in their processes and practices.

Our guide sets out how we expect banks to adopt a forward-looking, comprehensive and strategic approach to climate-related and environmental risks. We believe that such an approach is required to cater for the specific characteristics of these risks, including their far-reaching impact in terms of the regions and business activities affected, the uncertain and extended time horizon and the need for short-term action. We expect banks to start incorporating climate-related and environmental risks when formulating and implementing their business strategies and their governance and risk management frameworks. This also requires banks to provide greater transparency by enhancing their climate-related and environmental disclosures.

In short, the guide describes how ECB Banking Supervision expects banks to consider, manage and disclose climate-related and environmental risks in the light of current regulatory requirements. By doing so, we intend to provide transparency about the ECB’s understanding of safe and prudent management of these risks within the current prudential framework, increase the industry’s awareness of these risks and improve risk management practices.

We are also closely coordinating our approach with other supervisors and with regulators. Our guide has been developed together with the national competent authorities; it is consistent with and builds on recent publications by a number of these authorities. At the EU level, we contribute to the work of the EBA, which has already published its action plan on sustainable finance and will deliver on a number of mandates in the coming years. We are also actively involved in the NGFS, the network of central banks and supervisors that represents those responsible for half of all global greenhouse gas emissions across five continents and that supervises three-quarters of global systemically important banks. And we are pleased to see that international standard-setting bodies such as the Basel Committee on Banking Supervision have recently announced initiatives in this field, a sign of growing momentum at the global level.

We have launched a long consultation on our draft guide to ensure that all banks have a chance to carefully consider our draft expectations. Banks and other stakeholders are invited to provide their feedback by the end of September. We encourage you to read the guide, if you haven’t already done so, and we anticipate that the public consultation will provide valuable input for finalising it.

Once the guide is finalised, we expect banks to assess whether their current practices are safe and prudent in the light of our supervisory expectations and to start adapting their practices where necessary. We recognise that risk management methodologies in this field are evolving and that banks might need some time to update their practices. But we expect them to start taking action now. We will enter into a supervisory dialogue with banks as of next year in order to discuss practices that diverge from our expectations and examine banks’ plans to address these gaps.

We will also continue to develop our supervisory approach to the management and disclosure of climate-related and environmental risks. In doing so, we will closely monitor any updates to the regulatory framework and take any relevant developments into account.

Let me conclude by reaffirming the ECB’s commitment to these issues. As a prudential supervisor, we are and will remain dedicated to ensuring the resilience of banks, which includes addressing these new sources of risk. We need to act now to overcome the challenges of climate change.

We can then also reap a double dividend: not only can we better safeguard the banking sector’s resilience, but the adequate pricing of climate risks can drive a smoother and faster transition to a more sustainable economy.

I will now hand over to Patrick Amis, who will take you through the first session of this webinar on incorporating climate and environmental risks into banks’ strategies and risk management. I hope you find this webinar interesting and insightful.