Mapping connected dots: how climate-related and environmental risk management is becoming a reality
Speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at a workshop organised by the International Monetary Fund’s South Asia Regional Training and Technical Assistance Center and Monetary and Capital Markets Department
Frankfurt am Main, 10 December 2021
Thank you for inviting me to speak at this IMF workshop on addressing climate risks in prudential supervision and regulation. It is a great pleasure to join you today to speak about addressing climate risks in prudential supervision and regulation – both because of the importance of this topic and because it draws a common thread between many of my roles. First, as Chair of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Second, as Co-chair of the Basel Committee on Banking Supervision’s Task Force on Climate-related Financial Risks. And third, as Vice-Chair of the ECB’s Supervisory Board.
I am not only Vice-Chair of the Supervisory Board, but also a member of the ECB’s Executive Board and Governing Council. We are now in our quiet period leading up to a monetary policy meeting, which means that I will not say anything today that has any bearing on the deliberations of the Governing Council next week.
That being said, the topic of this workshop leaves us plenty to discuss. Addressing climate-related – and I will consistently add environmental – risks in prudential supervision and regulation has many dimensions and perspectives. Still, considering the impressive agenda that the organisers have put together for this event, I had to think hard about the best angle to take in my remarks today to complement the contributions of other speakers. You will hear from the head of the NGFS Secretariat Jean Boissinot, who will present the NGFS’s Guide for Supervisors and its recently published progress report on that Guide. My colleague Patrick Amis will present the activities of ECB Banking Supervision in more detail. And there will be interesting presentations on the approaches and experiences of the South Asia region.
With so much progress being made in so many different places, we risk losing sight of the broader picture. Therefore, I thought it would be useful to share what can be described as the perspective of the travelling salesperson. In short, the travelling salesperson problem considers the following question: “given a list of cities and distances between each city, what is the shortest possible route that connects all cities?” In other words, the travelling salesperson sets out to complete a “connecting the dots” exercise as efficiently as possible to make her task – visiting all cities – a reality. This is what I will aim for in my contribution today: connecting the dots of different activities in the global policy community, which – once connected – reveal how the prudential supervision and management of climate-related and environmental risks is becoming a reality. In a way, I would like to be your “net zero travelling salesperson” for today.
The NGFS Guide for Supervisors
The NGFS’s journey started exactly four years ago this Sunday: the day the network was founded . Over these past four years, our network has quickly grown from eight founding members in 2017 to 102 central banks and supervisors and 16 observers today. The NGFS is a global and inclusive network – our members include central banks and supervisors across five continents, they come from developed, emerging and developing economies, and they cover 88% of the global economy and 85% of all global emissions.
Since launching the NGFS in 2017, we have developed and shared tools and knowledge to better equip central banks and supervisors to deal with climate-related and environmental risks in all their tasks and responsibilities. In our first comprehensive publication, the 2019 “Call for Action” report, we acknowledged that the physical and transition risks from climate change are a source of financial risk and that, as a result, it falls squarely within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks. One of the six recommendations included in this early NGFS publication was to integrate climate-related risks into financial stability monitoring and microprudential supervision – by mapping and monitoring the relevant risks and their transmission channels, by engaging with supervised entities and by establishing supervisory expectations. On supervision, we followed up with a further five concrete recommendations in our Guide for Supervisors published in May 2020.
Later in today’s workshop, Jean Boissinot will present the conclusions of a recently published report on the progress made in following up on these recommendations. For now, let me highlight one finding of particular relevance. We are seeing that more supervisors are clarifying how existing legal requirements will be applied in the context of climate-related and environmental risks. This clarification of what supervisors expect from supervised entities will guide the supervisory dialogue in the future. Both supervisors and financial institutions are in the early stages of the journey towards sound management of climate-related and environmental risks. It is therefore to be expected that the guidance will be refined and the bar will be raised over time as expertise and regulations are developed and capabilities are improved. But setting expectations is still an important step, given the urgent need for financial institutions to start integrating climate-related and environmental risks into their decision-making and risk management processes. This is also acknowledged by the banks themselves as evidenced by the recent GFANZ initiative that has banks voluntarily entering into commitments reach net zero, with intermediate targets and consistent transition planning.
The ECB experience
One of the institutions that is making swift progress in formulating expectations and discussing them with supervised banks is the institution I know best, the ECB. A year ago, we published our Guide on climate-related and environmental risks for banks, demonstrating the ECB’s commitment – within its mandate – to making the financial system more resilient to these risks. In the Guide, we set out 13 supervisory expectations for how the banks under our direct supervision should integrate climate-related and environmental risks into their business models and strategies, governance and risk appetite.
As a follow-up to that Guide, we recently published the findings of a benchmarking exercise in which we thoroughly reviewed the practices and plans of the largest banks in the euro area across more than 130 focus areas. We carried out this exercise on the basis of the banks’ own assessments of their performance against our expectations. Covering 112 directly supervised banks with €24 trillion in combined assets, the exercise was an unprecedented stocktake of European banks’ preparedness to adequately manage and disclose their exposure to climate-related and environmental risks. By publishing our findings, we are providing an overview of the current trends in addressing and disclosing these risks within the euro area banking sector. We are also sharing some existing good practices for managing these risks in the hope that banks can draw inspiration from them to mitigate the gaps identified so far and to considerably step up their risk management efforts in this area.
In my remarks today, I will not give away too many details from the report that my colleague Patrick Amis will present later. But I am often asked whether I am pleased or disappointed with the findings from the banks’ self-assessments. My answer to this question comes in two parts. First, yes, I am disappointed because we are becoming increasingly aware of the gap between where we stand and where we need to be to become Paris-compatible. And the banks’ self-assessments show that they are not doing much better in terms of living up to our expectations. Almost all banks that took part in the exercise are only partially – or not at all – aligned with the ECB’s supervisory expectations. And this is in a situation where many of the banks already recognise that climate-related and environmental risks will have a material impact on their risk profile within the next three to five years. That being said – and this is the second part of my answer – I am very pleased about how forthcoming the banks have been in their self-assessments. The fact that banks have been very candid and do not seem to have applied any greenwashing suggests that they are willing to engage and to learn. And the good practices – seen across all our expectations and all types of bank in terms of business model, size and location – confirm that there is scope to learn and to close the gap between current practices and our expectations.
It is against this backdrop that the ECB will move forward with its supervisory agenda on climate-related and environmental issues. In 2022 we will carry out a thematic review of institutions’ climate-related and environmental risk management practices and conduct a supervisory stress test with a view to gradually integrating these risks into the Supervisory Review and Evaluation Process methodology.
The Basel Committee on Banking Supervision
In addition to the recommendations and progress made in the informal context of the NGFS and the steps taken by many individual institutions like the ECB, the international standard-setting bodies are also becoming active in this area and providing a layer of global consistency. Here, I am thinking of the ambitious work programmes of the Financial Stability Board and other multilateral organisations, and the recent creation of an International Sustainability Standards Board. But let me finish today by highlighting an initiative spearheaded by the Basel Committee on Banking Supervision (BCBS).
The BCBS acknowledges that climate change may have an impact on the safety and soundness of financial institutions, as well as broader financial stability implications for the banking system as a whole. Climate-related financial risks will therefore be one of its main priorities in the coming years. In this context, the BCBS set up the Task Force on Climate-related Financial Risks (TFCR) specifically to explore how best to mitigate risks to banking institutions and the banking system arising from climate change. It’s a large group, too – participants come from more than 40 BCBS member authorities and include central banks and supervisors. Together with Kevin Stiroh from the Federal Reserve System, I am pleased to co-chair this task force.
The TFCR has been busy since its launch in February 2020. By April of the same year it had prepared a report taking stock of existing initiatives on climate-related financial risks. And earlier this year it published two analytical reports – one on risk transmission channels and another on measurement methodologies – both of which offer some good news. They concluded that the traditional risk categories of the Basel framework – such as credit risk, market risk and liquidity risk – can also be used to capture climate-related financial risks. This means we have a solid foundation for the BCBS’s future approach to climate issues: instead of treating climate-related financial risks as a new and separate risk type, we can look at how to tackle them within the current structure of the Basel framework. This will considerably speed up our action in this area. However, the task force also found that there are still challenges in terms of data availability and measuring climate-related financial risks. It therefore committed to pursuing its work to identify potential gaps in the current framework and consider possible measures of addressing them. In line with the BCBS’s guidance, this work will be comprehensive in nature and encompass all pillars of the Basel framework, so regulation, supervision and disclosure practices.
In November 2021 the BCBS issued principles for the effective management and supervision of climate-related financial risks – testament to the fact that the Committee’s work is not just talk and analysis, but also action. Essentially, the BCBS is seeking to promote a principles-based approach to improving both banks’ risk management and supervisors’ practices for climate-related financial risks. Given the many ongoing initiatives in this area, the aim of the principles is to strike a balance between improving practices and providing a common baseline for internationally active banks and supervisors, while maintaining sufficient flexibility. Importantly, we wanted to ensure that the proposed principles are aligned with the general requirements of the existing BCBS guidelines, making it easier for banks and supervisors to incorporate the principles into their existing frameworks and practices.
The first set of principles provide banks with guidance on how to effectively manage climate-related financial risks. Banks should, for instance, consider the impact of climate-related risk drivers on their individual business models and assess the financial materiality of these risks. They should also continuously develop their capabilities and expertise on climate-related financial risks and ensure they allocate the appropriate resources to manage them.
The second set of principles provide guidance for prudential supervisors, with a focus on their responsibilities, powers and functions. For instance, supervisors should ensure that they too have adequate resources and use an appropriate range of techniques and tools, including climate-related risk scenario analysis.
The BCBS invites comments on the principles from the industry, experts and other stakeholders by 16 February 2022 and is aiming to finalise them by mid-2022. Feedback is particularly welcome on the question of how the principles could also cater for broader environmental risks in the future. Given the increasing importance of climate-related financial risks, the BCBS encourages its member jurisdictions to implement these principles as soon as possible. It intends to monitor implementation to promote a common understanding of expectations and support the development of harmonised practices. As such, the BCBS is bringing together many elements of the work done by supervisors – both individually and together in the NGFS – in a more formal and globally consistent framework.
Let me conclude. I have outlined three interconnected dots which, together, clearly reveal how the management of climate-related and environmental risks is becoming a reality. We have now reached the point where there is a positive interaction between the dots, ensuring that individual dots will become bolder, and the connections become stronger. This is good news but provides no grounds for complacency – because we know the global banking sector is still a long way from treating climate-related and environmental exposures like any other exposure, while physical and transition risks are increasing. So to get where we need to be, we all need to be ready to both lead and learn. We need to keep adding and connecting dots. We all need to be “net zero travelling salespeople”.
- NGFS (2019), “A call for action: Climate change as a source of financial risk”, April.
- NGFS (2020), “Guide for Supervisors: Integrating climate-related and environmental risks into prudential supervision”, May.
- NGFS (2021), “Progress report on the Guide for Supervisors”, October.
- Glasgow Financial Alliance for Net Zero.
- ECB Banking Supervision (2020), “Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure”, November.
- ECB Banking Supervision (2021), “The state of climate and environmental risk management in the banking sector: Report on the supervisory review of banks’ approaches to manage climate and environmental risks”, November.
- For an overview, see Elderson, F. (2021), “How well are European banks managing their climate-related and environmental risks?”, The Supervision Blog, 22 November.
- Basel Committee on Banking Supervision (2020), “Climate-related financial risks: a survey on current initiatives”, April.
- Basel Committee on Banking Supervision (2021), “Climate-related risk drivers and their transmission channels”, April.
- Basel Committee on Banking Supervision (2021), “Climate-related financial risks – measurement methodologies”, April.
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