Climate-related and environmental risks – a vital part of the ECB’s supervisory agenda to keep banks safe and sound

Introductory remarks by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the panel on green finance policy and the role of Europe organised by the Federal Working Group Europe of the German Greens

Frankfurt am Main, 23 June 2023

Thank you for inviting me to this panel. I am looking forward to exchange views with you – legislators and policymakers – about the role that finance may play in tackling the ecological polycrisis we are facing. In my remarks today, I will outline how ECB Banking Supervision considers climate-related and environmental aspects in fulfilling our mandate to keep European banks safe and sound.

ECB Banking Supervision’s roadmap for climate and environmental risks

The window for aligning our economy with the goals of the Paris Agreement is narrowing. Earlier this year the Intergovernmental Panel on Climate Change stressed that global warming is already on the verge of crossing the threshold of 1.5 degrees Celsius. In light of this alarming observation, we cannot ignore that the ongoing climate emergency will render our economy more susceptible to shocks at a time when it is undergoing one of the biggest structural transformations in modern history.

As also mentioned in a speech by ECB President Christine Lagarde this morning^[1], let me stress that these shocks are not only limited to climate change. We are currently also observing an unprecedented decline in natural ecosystems and the vital services they provide such as pollination, clean water or healthy soil. We witness that 75% of land surface, and 66% of ocean, ecosystems have been damaged, degraded or modified.^[2] This also has economic implications given that more than half of global GDP depends on nature.^[3] At the ECB we recently assessed the dependence on ecosystem services of more than 4.2 million individual companies in the euro area. Our preliminary assessment suggests that 75% of bank loans in the euro area are to companies that are highly dependent on at least one ecosystem service.^[4]

This is not some kind of tree-hugging exercise. We are talking about material financial risks arising from biodiversity loss. Putting it even more bluntly: if we destroy nature, we destroy economic activity, and this will ultimately have a material impact on the banking system. Similarly, the material financial risks arising from the climate emergency will affect banks. So even if I couldn't care less about biodiversity, even if I couldn't care less about climate change, as a banking supervisor I need to be utterly concerned as this comes down to the very essence of our mandate. It goes to the heart of financial stability, the soundness of banks and the resilience of our banking system. In other words, if we did not take climate, environment, biodiversity and nature-related aspects into account, we would be failing to deliver on our mandate.

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 reflected on how the climate and environmental crises affected their strategy. Acting on this concerning observation, in 2020 the ECB published a guide on climate-related and environmental (C&E) risks^[5] for banks, setting out supervisory expectations for how banks should integrate these risks into their business strategy, governance and risk management. In 2022 we also made C&E risks one of our main supervisory priorities for the next three years. ^[6]

Where we stand

So where do banks under our supervision currently stand in terms of incorporating climate-related and environmental aspects into their practices?

After publishing our supervisory expectations in 2020, we conducted several supervisory exercises over the following two years to assess banks’ approaches to managing these risks. These exercises gave us a full picture of how banks are performing relative to our supervisory expectations.

In a nutshell, we see the glass filling up slowly, but it is not even half full yet. This “filling up” is good news because, compared with where they started a few years ago, banks have made meaningful progress in accounting for C&E risks. But the “not even half full yet-part” is bad news because banks are still a long way from where they need to be.

Yes, the climate and environmental crises have made it to the top levels within banks and some steps have been taken. But there is a big difference between beginning to act and doing what is actually needed. On the positive side, most banks acknowledge the materiality of the climate-related risks in their portfolios. However, we have seen less progress on environmental risks, with 40% of banks not yet having properly assessed their exposure. This means that in many cases the basic housekeeping measures required to identify and manage these risks have not yet been put in place. So there is still, overall, a material gap between our supervisory expectations and where banks currently stand. To be clear, it is not for us, as supervisors, to tell banks how green their lending policies should be. However, we will continue to insist that ignoring climate-related and environmental factors is no longer compatible with sound risk management.

Let me also highlight that there are some frontrunners among banks that show that what we are asking is doable. For example, some pioneering banks are already including climate‑related and environmental adjustments in their models for the calculation of loan loss provisions ^[7]. In addition, some banks are already allocating capital to environmental risks in their internal capital calculations.

The path ahead

However, we need full compliance with all our expectations – and we need all banks to do that, not just a few frontrunners. We have set the end of 2024 as the final deadline for banks to comply with all of our supervisory expectations. Against that backdrop, we will continue to scale up our supervisory activities on C&E risks.

One of the silver linings of our supervisory exercises of last year is that we have published the good practices we have observed^[8]. This gives banks practical suggestions to promptly progress in closing the gaps to our expectations. By now all key ingredients to make C&E risks an integral part of banks’ strategy and risk management are on the table. But banks are in the lead when it comes to translating ambitions into practice.

To smooth the transition to the final deadline in 2024, we have also set some intermediate deadlines, requiring banks to reach specific milestones. For example, by the end of March this year we asked all banks to make an explicit assessment on the impact of C&E risks in the short, medium and long term across their portfolios. Simply kicking the can down the road with the myopic view that C&E risks are not material is no longer acceptable. Our supervisory teams are currently assessing banks’ compliance with this first intermediate deadline. The next intermediate deadline is at the end of this year, when we ask banks to clearly include C&E risks in their governance, strategy and risk management. At each step along the way, we will identify remaining gaps and decide what action is needed to close them.

We will use all measures in our toolkit and, if needed, step up the supervisory escalation to ensure compliance with our expectations. This may include periodic penalty payments as enforcement action or imposing bank-specific capital add-ons^[9].

Let me conclude.

Humanity needs nature to survive and so do our economy and our banks.

Consequently, destroying nature and contributing to a worsening of climate change means destroying economic activity.

Preventing the former is in the realm of you – elected politicians and government representatives - as climate and nature policymakers.

We as ECB Banking Supervision must – and will – play our part by taking C&E risks into account in the fulfilment of our mandate to keep banks safe and sound. This will make sure that the banking system is resilient to the ongoing twin climate and environmental crises, and that banks are prepared for a net‑zero carbon future.

Thank you for your attention. I look forward to our exchange of views.