Welcome address by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, ECB Industry Outreach event on Climate-related and Environmental Risk
Frankfurt am Main, 3 February 2023
Sometimes it can take a while before good things come to their fullest fruition in mainstream popular culture. Last year this happened to the song by Kate Bush “Running Up That Hill”. Some 37 years after it first hit the charts, it topped the charts again in 2022 after featuring in a popular – many would say extremely exciting – drama series. The song even outperformed its listing in the 1980s. I have to admit that I actually missed the song on its first release when I was in high school. But it caught my attention when it hit the charts again last year. Not so much for its nostalgia, but for its message. Because I realised that the song is about gaining a better understanding of each other. About a woman and a man in a relationship swapping places to better appreciate the challenges each of them faces.
By now, you may be wondering where this welcome address is heading. Well, very much like “Running Up That Hill”, the topic of today’s industry outreach event – climate-related and environmental (C&E) risks – also turned mainstream in 2022. In this case the ECB’s mainstream banking supervision. In addition, the ECB’s joint industry outreach events bring together supervisors, and senior representatives from banks under European banking supervision. Supervisors and bankers cannot legally swap places like the woman and the man in the song by Kate Bush. But the ECB’s joint industry events are likewise about us better understanding the challenges each of us faces in pursuing common objectives. Today will allow us to share our collective knowledge and expertise and to discuss how to move C&E risk management to the next level in banks’ strategies, governance, and risk management frameworks. Today will allow us to learn how C&E risks have now entered mainstream thinking for not just supervisors, but also to an increasing extent for banks. Today will be about what banks still need to do to translate this thinking into their mainstream practices. Before going into more detail on this, let me first talk you through where we currently stand with respect to the supervision and management of C&E risks in the European banking sector and how we have come this far.
The road so far
Just three years ago, five years after the Paris Agreement, our early supervisory assessments suggested that less than a quarter of European banks under our supervision had demonstrably reflected on how the climate and environment crises affected their strategy. Moreover, about half of a representative sample of banks, without serious analysis, declared the risks immaterial in their internal capital adequacy assessment process. Faced with this worrisome observation, in late 2020 ECB Banking Supervision published its Guide on climate-related and environmental risks. The guide sets out 13 supervisory expectations for how banks should integrate these risks into their business strategy, governance and risk management. In issuing this guide, we were moving in lockstep with the evolving global principles for supervising C&E risks. At first, these principles reflected an informal global consensus, building on the prevailing best practices identified by the global Central Banks’ and Supervisors’ Network for Greening the Financial System (NGFS). By now, however, a concrete formal global consensus has been enshrined in the principles for the effective management and supervision of these risks, published by the Basel Committee on Banking Supervision in June 2022. To advance this work at the global level, the Basel Committee has set up a task force, which I co-chair.
During the two years after publishing our supervisory expectations, we conducted several supervisory exercises on banks’ approaches to managing these risks. We started with bank self-assessments in 2021, followed by a climate stress test and thematic review of C&E risks in 2022. As I have said before, the supervisory exercises of last year were the stepping stone to what I would call an immersive supervisory approach. An encompassing and integrated approach, in which C&E risks will feature in all parts of the supervisory dialogue and interaction. An approach that is not new to banks, because they are already familiar with it for traditional risk categories. In other words, an approach that is mainstream for material risks.
Last year’s exercises did more than integrating C&E risks into our mainstream supervision. They also gave us a full picture of how banks perform relative to our supervisory expectations. And looking at the results alongside our initial assessments, those exercises show that banks have made meaningful progress in accounting for and addressing C&E risks. In recent years banks have shown that they acknowledge the materiality of these risks in their portfolios and have made progress in building up their risk management frameworks and processes. However, as I will illustrate, the glass is not yet full. It is not even half full. Against this backdrop, we are calling on you to take the actual management of these risks to the next level.
Where we stand today
Let me now reflect – in the light of the two major supervisory exercises that we conducted last year − on where the whole banking sector stands in terms of actual business and risk management practices compared with our expectations. First, the 2022 climate risk stress test was designed as an important learning exercise for us and you on how resilient banks are to C&E risks. We assessed among other things banks’ climate risk stress test frameworks, but also the sustainability of income sources vis-à-vis the green transitions. Second, the comprehensive thematic review looked at banks’ practices related to the strategy, governance and risk management of C&E risks. It aimed to assess whether banks’ C&E risk management practices were evolving to be sound, effective and comprehensive. And it looked into whether banks were able to adequately steer their C&E risk strategies and risk profiles. We also checked whether banks had followed up on the feedback we had issued the year before based on the self-assessments.
Referring to the results of the thematic review, I observed that the glass was filling up slowly, but was not yet even half full. Yes, the climate and environmental crises have made it to the top levels within banks and some first steps have been taken. But there is a difference between talking about steps and taking action; and an even bigger gap between talking and doing what actually needs to be done. In a nutshell, despite the progress made, we have concluded that, in practice, risk management capabilities are still insufficient overall. Let me illustrate this with two overarching points.
First, we identified blind spots in the assessment of C&E risks among all the institutions we assessed. One such blind spot is the lack of consideration of the physical risks of the climate and environmental crises. We do see transition risk practices being implemented across banks’ processes, but too often physical risks are too narrowly addressed. Banks do perform impact analyses of the possible consequences for their own business continuity and have processes in place to restore critical services if needed. However, they broadly underappreciate the impact of physical risks and how such impact can affect their balance sheets. For example, even though water stress – already affecting 30% of Europeans in an average year – is on the rise, less than one-third of banks consider this risk driver in their strategic risk impact assessments. Unfortunately, this observation is not contained to materiality assessments. We see an underappreciation of physical risk in many critical areas, like strategy-setting, data governance, due diligence and credit risk management.
A similar blind spot applies to the management of broader environmental risks beyond climate. Our supervisory expectations explicitly apply to the management of both climate-related and environmental risks. This is consistent with the consensus established through the NGFS that both are sources of material financial risk. However, many banks have so far only come up with a high-level description of the general impact of other environmental risks on vulnerable sectors like agriculture, mining and manufacturing, and they are yet to perform adequate materiality assessments regarding environmental risk in particular.
A second shortcoming in banks’ current practices is that they are not addressing the C&E risks they face in a sufficiently strategic manner. Banks’ management boards rarely set in motion actual shifts in strategic direction or changes in meaningful risk limits. By way of example, we found that fewer than 5% of banks have a systematic process for evaluating the appropriateness of their human and financial resources to manage these risks. This undermines their capability to respond appropriately to the C&E risk management needs that will arise. But perhaps this is unsurprising given that internal reporting is still in its infancy. Through our exercises we have observed a steep increase in the number of banks setting up key risk indicators to measure the risks that they are exposed to, from less than one-fifth to two-thirds of banks. However, the quality and comprehensiveness of these risk indicators often leaves much to be desired – only 5% of banks were found to have established sufficiently granular risk indicators. By granular we mean that we want to see risk indicators that are sensitive to firm-specific risk profiles and make use of more risk-sensitive data that go beyond sectoral or geographical classifications. Using less granular information as proxies is of limited use if you want to properly identify, monitor and manage C&E risks.
As another example, we found that governance limitations apply across banks’ organisational structures all the way to their third line of defence – internal audit. Few banks explicitly define the tasks and responsibilities of the internal audit function with respect to C&E risks. This means that only a handful of banks’ management bodies actually receive an independent internal assessment of their C&E performance. Similarly, in the climate stress test we found that most banks do not ensure independence between the development of climate stress-testing frameworks and their validation processes.
As an outcome of these supervisory exercises, we sent extensive feedback letters to banks, highlighting the gaps we had identified. We also published two separate reports outlining the good practices that we observed in both the climate stress test and in the thematic review. The banks therefore have access to very practical suggestions based on existing practices for making swift progress in closing the gaps between their practices and our expectations.
Meanwhile, we have continued to incorporate the supervision of C&E risks into our existing supervisory methodologies, such as our fit-and-proper guidance and our on-site inspections. In fact, we are close to presenting the outcome of last year’s annual Supervisory Review and Evaluation Process (SREP) which, for quite a number of banks, will include qualitative requirements that they address shortcomings. A small number of banks will see their SREP scores negatively affected due to C&E-related considerations, without those impacts on the scores translating into overall higher capital requirements in this specific cycle. In addition, we have made climate-related data requests part of our regular supervisory data request under the SREP process. Finally, we have just conducted our third annual assessment of C&E risk disclosures. All this confirms that C&E risks form an integral part of our ongoing dialogue and interaction with supervised entities. They are no longer considered in isolation.
Where we are heading
Let me now explain where we are heading. The awareness that sound C&E risk management in the financial sector is of crucial importance can now be considered mainstream − in global regulatory and supervisory standards, in the ECB’s supervisory policies and methodologies, in our Joint Supervisory Teams, and in the banks via their materiality assessments. And you – the banks – are in the lead when it comes to translating this awareness into mainstream practices by designing and implementing specific, practical tools to adequately manage these risks.
With this event we hope to encourage you, as an industry, to consolidate your ability to set risk management standards in the global move towards sustainable finance. As a supervisor, our task is to see to it that banks have adequate risk management practices in place. As I have underlined consistently on other occasions, it is not for us as supervisor to swap places with you and tell you how green or non-green your lending policies must be. However, we will insist that continued non-green lending without incorporating in your assessments and decisions clients’ credible and science-based Paris-aligned transition plans is no longer compatible with sound risk management.
Earlier this week climate scientists have warned us that global warming is already on the verge of crossing the 1.5 °C threshold. Therefore, time is of the essence in establishing the business practices that are needed to address the increasing risks from the ongoing climate and environment crises. This is why we expect all the banks we supervise to be fully aligned with all our expectations by the end of 2024 at the latest. And this is why we will take enforcement action if necessary. Hence, 2023 is yet another crucial year for making progress. Our supervisors will closely monitor how banks have progressed against their intermediate, institution-specific deadlines. Not only in terms of developing formal processes, but also in terms of actual responses effectively addressing risks and enhancing resilience of exposures. By the end of March 2023 at the latest, we expect the institutions that had not yet done so and thus had not joined the mainstream in this regard, to have in place a sound and comprehensive materiality assessment.
Going beyond these initial next steps, in the upcoming years there will be targeted deep dives and on-site expectations for areas of concern and to closely assess compliance with upcoming disclosure requirements. Our Joint Supervisory Teams will stay in close contact with you and your colleagues throughout this journey, actively engaging on C&E risks as part of the ongoing supervisory dialogue.
Let me conclude.
The woman in Kate Bush’s song expresses her desire to swap places with her counterpart, so she would be the one running up the hill. I must admit that I feel a similar urge with respect to getting on top of C&E risks. At the same time, we are mindful of the challenges you face in aligning with our supervisory expectations. It is therefore crucial that we maintain the ongoing dialogue between supervisors and banks, and that we facilitate the exchange of good practices and experiences between banks. That is why I believe this event is the perfect opportunity to share and leverage the knowledge that is available within your industry to bolster your collective resilience against C&E risk. To appreciate that the awareness of the need to manage climate-related and environmental risks in a timely and sound manner has become mainstream. It is high time to run up that hill.
ECB Banking Supervision (2020), “ECB report on institutions’ climate-related and environmental risk disclosures”, November.
ECB Banking Supervision (2020), “ECB report on banks’ ICAAP practices”, August.
ECB Banking Supervision (2020), “Guide on climate-related 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”, keynote speech at the Industry outreach on the thematic review on climate-related and environmental risks, 18 February.
Elderson, F. (2022), “Banks need to be climate change proof”, The Supervision Blog, ECB Banking Supervision, 2 November.
NGFS (2022), “Statement on Nature-Related Financial Risks”, 24 March.
ECB Banking Supervision (2022), “Walking the talk Banks gearing up to manage risks from climate change and environmental degradation - Results of the 2022 thematic review on climate-related and environmental risks”, November.
ECB Banking Supervision (2022), “ECB report on good practices for climate stress testing”, December.
ECB Banking Supervision (2022), “Good practices for climate-related and environmental risk management – Observations from the 2022 thematic review”, November.
Diffenbaugh, N.S. and Barnes, E.A. (2023), “Data-driven predictions of the time remaining until critical global warning thresholds are reached”, PNAS, Vol. 120, No 6.