The way towards banks’ good climate change risk management
Keynote speech by Anneli Tuominen, Member of the Supervisory Board of the ECB, at the 9th Conference on the Banking Union
22 September 2022
I am happy to be here today to speak about climate risks for banks at the 9th Conference on the Banking Union. While recognising the importance of social and governance factors, I will focus today on climate-related and environmental risks for banks.
One of the ECB’s main supervisory priorities has been to ensure that banks emerge from the pandemic healthy. The start of 2022 looked promising in this respect. Thanks to the extraordinary support measures, the banking sector did not seem to be suffering major asset quality problems, and the profitability outlook was good.
However, following Russia’s aggression against Ukraine, the situation has changed dramatically. The systemic risks originating from a deteriorating economic outlook and high indebtedness have increased. Meanwhile, geopolitical risks have led to high energy prices and supply shocks disrupting the economy. We are also seeing a sizeable increase in the cost of risk, together with lower lending volumes owing to low demand. All of this will have an impact on banks. It is however questionable whether governments are as willing or as able to support businesses as they were during the pandemic.
But what does this mean for climate-related and environmental risks? Will the impact of the war lead to a temporary postponement of the transition to a greener economy, or will it instead accelerate the transition thanks to technological innovations and reorientation of investments? Banks need to be prepared for both scenarios. Strong expertise and knowledge of climate issues, also at board level, will be essential as banks confront the enormous challenges posed by climate change.
Preparedness and vulnerabilities of banks
Climate-related and environmental risks for banks include the transition towards a more sustainable economy and the need to adapt to increasing physical threats. Tackling climate-related and environmental risks is one of the ECB’s key supervisory priorities for 2022-24. We have therefore set a strategic objective for banks to proactively incorporate climate-related and environmental risks into their business strategies and their governance and risk management frameworks. This will enable banks to mitigate and disclose such risks and comply with the corresponding regulatory requirements. But where do banks stand at present?
The ECB has carried out several supervisory exercises that have provided information on banks’ preparedness.
In 2020 the ECB published its Guide on climate-related and environmental risks, outlining its supervisory expectations regarding banks’ risk management and disclosure in this area. Subsequently, banks were asked to perform a self-assessment. In doing so, most banks recognised that they have significant exposures to climate-related and environmental risks. However, 90% of the banks said that they were only partially or not at all aligned with the ECB’s supervisory expectations and, in particular, saw a need to improve the way they manage and disclose these risks.
This year, climate-related and environmental risks have been further integrated into the day-to-day supervisory tasks, forming part of the ongoing dialogue with banks and the annual Supervisory Review and Evaluation Process – the SREP. As part of the SREP, climate-related and environmental risks can ultimately influence banks’ minimum capital requirements.
In addition, a climate-stress test was carried out this year as a learning exercise for both banks and supervisors. The results show that banks do not yet sufficiently incorporate climate risk into their stress-testing frameworks and internal models in accordance with the expectations laid out in the ECB’s guide, although some progress has been made since 2020.
How far banks are currently aligned with the ECB’s expectations is a focus of the ongoing thematic review, which covers both significant and less significant banks. The outcome of this thematic review will be published later this year. I can already say that we have seen positive developments. For instance, banks have more board-level expertise on climate-related and environmental risks and have improved their governance structures.
At the same time, there are still clear gaps relative to the ECB’s supervisory expectations. For example, although both physical and transition risks are becoming increasingly material, banks continue to focus their strategies more on transition risks than on physical risks. This worries me, not least because we saw the large impact of physical risk events again this summer, when drought and flooding heavily disrupted industries and regions.
Another area where banks should strive to make further progress is risk management. The climate stress test revealed that almost two-thirds of bank income from non-financial corporate customers stems from greenhouse gas-intensive industries, and “financed emissions” often come from a small number of large counterparties, increasing banks’ exposure to transition risks. Banks are expected to fully incorporate climate-related and environmental risks into their risk management procedures and use all instruments at their disposal to identify and actively manage these risks.
Banks should have a proper understanding of their exposures and investment targets. With this information, they would be able to adjust client ratings based on energy performance and help clients to mitigate climate-related and environmental risks. Knowledge of these risks will also make it easier for banks to accurately disclose their impact on their risk profile and on their efforts to align their portfolios with the goals of the Paris Agreement.
However, we are not there yet. Although the level of disclosure has improved since 2020, when we published our supervisory expectations, there is still room for improvement. Regarding both disclosure and risk management, banks are lacking reliable data. We know that taxonomy disclosures are challenging for banks and in this field, we support further work on improving the framework. On the other hand, we saw in our targeted review on climate risk integration into commercial real estate that many banks were lacking data and instead were using proxies. There is a need for banks to step up their customer engagement to obtain more accurate data. At the same time various regulatory initiatives might help here. I will come back to these later.
If banks do not meet the targets they have announced or follow the climate strategy they have communicated, they expose themselves to litigation and reputational risks. For instance, failing to meet commitments to align their activities with the goals of the Paris Agreement may increase the likelihood of legal obligations being enforced. This emphasizes the need for banks to provide clear, detailed and prudent transition plans. From a prudential perspective the main concern that needs to be addressed by these transition plans is the level of banks’ risk exposures and the effectiveness of their controls.
In addition, it is crucial for banks to accurately disclose environmental, social and governance (ESG) risks in their product-related information for clients. Banks can be accused of greenwashing if the information they disclose is misleading. The threat of legal cases following greenwashing must be taken seriously, and banks should take care to ensure that the information on their sustainable products is correct, be they sustainability linked bonds or ESG funds. As a good move forward, I see the future European Green Bond standard which would set transparency and external review requirements for such a label to be used.
With regard to legal risks, the Network for Greening the Financial System (NGFS) concluded in a technical document published last year that “climate-related litigation is increasing across jurisdictions and is a fast-moving target”. According to the NGFS, there has been a clear increase in climate-related cases being filed around the world in recent years, and this trend is likely to continue. These cases have mainly been seen outside the financial sector. One example is the case against the company, Royal Dutch Shell: in May 2021 the District Court in the Hague ruled that the company must cut its greenhouse gas emissions by 45% by 2030. This ruling was based on a violation of the duty of care under Dutch law and human rights obligations. The NGFS also notes that cases are increasingly brought directly against financial institutions; a trend that will likely continue in the coming years.
Regulatory and policy changes
It is not only the banks that need to act, also supervisors, policymakers and regulators are doing their homework. The ECB’s supervisory actions on climate are part of broader international efforts to advance the supervision and regulation of climate-related and environmental risks. It is impossible to discuss all the legislative and policy proposals in detail today, so let me focus on some aspects that could have implications for the prudential and disclosure requirements imposed on banks.
Overall, the ECB supports the continuation of the work by the Basel Committee on Banking Supervision (BCBS) on all three pillars of the prudential framework.
Regarding the prudential framework, in my view, prudential requirements should respect banks’ risk profiles, and no non-risk based brown penalties or green supporting factors should be introduced.
The Pillar 1 framework is currently being examined to identify whether it adequately addresses climate-related and environmental risks. A European Banking Authority (EBA) discussion paper has been published on this topic and discussions within the BCBS are ongoing. The BCBS is taking a holistic approach across all three pillars of the Basel framework, analytically keeping all alternatives still on the table. Substantial progress has been made on the use of the Pillar 2 framework with the recent publication of BCBS principles for the effective management and supervision of climate-related financial risks. Yet, the materiality of climate-related financial risks requires us to look at all pillars of the Basel Framework, including potential Pillar 1 measures. Here, we need to bear in mind that climate-related and environmental risks are forward looking by definition and the reliance on historical data may affect the risk measurement which could require the consideration of new tools to complement the existing Pillar 1 framework.
Meanwhile, the EBA has published binding standards on Pillar 3 disclosures on ESG risks, setting mandatory and consistent disclosure requirements and providing banks with further clarity. The ECB is regularly assessing the banks’ climate-related and environmental risk disclosures. It has already sent feedback letters to banks early 2022 and published a report highlighting the main areas for improvement. The exercise will be conducted again towards the end of this year, with the option to publicly list banks which repeatedly fail to disclose their climate-related and environmental risks.
Extensive work has also been done at European and international level as regards sustainability disclosures. In the EU, the European Financial Reporting Advisory Group (EFRAG) is developing its draft European Sustainability Reporting Standard in line with the Corporate Sustainability Reporting Directive. Another important step in achieving globally harmonized disclosure standards is the development of the International Sustainability Standards Board (ISSB) standards.
In its reply to the ISSB consultation on its two drafts, the ECB emphasised the importance of a global baseline (a building block approach) given the global nature of climate and sustainability challenges. I couldn’t agree more. Interoperability will foster comparability and consistent information, providing banks and their stakeholders with greater clarity. To ensure the closest possible alignment and comparability between the two standards, the ECB also strongly supports the cooperation among the ISSB and EFRAG.
To avoid double reporting, consistency with existing Pillar 3 disclosure requirements should also be ensured. The ECB therefore recommends close cooperation between the ISSB and the BCBS. It also recommends that the standards undergo a more thorough process of due diligence and consultation with financial sector authorities.
A final interesting point I would like to share with you today concerns the incorporation of climate risk into credit ratings. It would provide key information for investors to use in assessing the overall riskiness of assets. The ECB noted in its recent publication that - even though disclosures and methodologies relating to climate risk have improved in credit ratings - there is still more work to be done, as the current level of disclosure does not give the user of the rating the understanding what the rating would have been in the absence of climate change risk. Through the use of reliable ratings, greenwashing could also be diminished. The European Securities and Markets Authority (ESMA) says that regulatory bodies are increasingly calling for issues regarding ESG rating providers to be addressed and the European Commission is assessing the need for regulatory safeguards for ESG ratings.
To conclude, reliable and meaningful disclosure together with high quality risk management and governance and interoperability of global standards are key.
I expect strong commitment and efforts from banks to ensure that they are fully aligned with the ECB’s expectations. Banks have made some progress since the expectations were published, but many challenges still lie ahead. To ensure adequate risk management procedures and disclosures, strong knowledge and expertise at board level is a must. Upcoming regulatory requirements and policy developments will help to provide banks with further structure and clarity on how to proceed. Overall, I am positive that banks should be able to comply with all of the ECB’s expectations by the end of 2024 at the latest.
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.
Elderson, F. (2022), “Towards an immersive supervisory approach to the management of climate-related and environmental risks in the banking sector”, speech at an industry outreach event on the thematic review on climate-related and environmental risks, 18 February.
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ECB Banking Supervision (2022), “2022 climate risk stress test”, July.
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European Banking Authority (2022), The role of environmental risks in the prudential framework, EBA/DP/2022/02, May.
European Banking Authority (2022), “Final draft implementing technical standards on prudential disclosures on ESG risks in accordance with Article 449a CRR.
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European Central Bank (2022), “Disclosure of climate change risk in credit ratings”, Occasional Paper Series, No 303, September.