On November 2nd 2022, the ECB published the long-awaited outcome of its thematic review into climate-related and environmental risks. Contained within the Guide on climate-related and environmental risk (“the Guide”) the ECB has set out clear expectations and has given banks 1,5 years to formulate their own implementation plans and take concrete steps to address climate-related and environmental risks (“CRE”).
The ECB states that banks should improve and accelerate their efforts to address CRE risk. If they do not do so in a comprehensive manner, then these improvements can be enforced as part of the Systematic Review and Evaluation Process (“SREP”). The ECB has set a final deadline for the Guide’s implementation for the end of 2024. In addition, intermediate deliverables are required from banks in March 2023 and year-end 2023 in anticipation of the 2024 deadline. On average banks within scope of the thematic review received 25 shortcomings for which remediation action is required.
Despite the emerging nature of the topic, the ECB expects banks to comprehensively implement all expectations into their strategy, governance, business processes and risk management frameworks. The ECB does not differentiate between less significant and significant institutions when setting its deadlines. For the first time, the ECB has explicitly said that it has given SREP requirements in relation to CRE risks. The SREP requirements were given to institutions that have not developed basic practices and that have missed deadlines described in their implementation roadmaps. These 30 significant institutions were found to have a number of major gaps in relation to the Guide.
For a small number of banks, the outcome of the 2022 supervisory exercises on CRE risks had an impact on their SREP scores, in turn, leading to an increase their Pillar 2 capital requirements. Now that the ECB has set a deadline for the end of 2024 banks will need to accelerate their implementation efforts based on the Guide to avoid SREP requirements. SREP requirements can be expected for banks where the ECB fears that the 2024 deadline will not be met unless further action is taken. Banks that have missed their own deadlines or have implementation dates beyond 2024 should revise their plans immediately.
The effective implementation of a sustainability strategy requires a cascade and embedding of the strategy into the entire organization.
The ECB expects banks to quickly mature and holistically consider all relevant CRE risks that span credit, market, operational, liquidity and strategic risk. Such assessments should be quantitative and consider the short, medium and long-term horizon. Many banks thus far have used a qualitative approach, applying a materiality assessment based on high emitting industries and credit risk. These banks have been asked to comprehensively re-perform their materiality assessments to include quantitative methods and cover the entire portfolio. In addition, the relative neglect of environmental risks beyond climate risk is noted.
To gain insight into their portfolios, banks have started to collect data on CRE risk and generate risk indicators. However, banking leadership does not yet appear to trust this as critical management information for decision-making. This is illustrated by low ambition levels for risk appetite and portfolio steering on CRE risk.
To accelerate integration of CRE risk within appetite and portfolio steering, banks should develop comprehensive CRE risk indicators that can provide meaningful contribution to steering activities.
The effective implementation of a sustainability strategy requires a cascade and embedding of the strategy into the entire organization. The risk appetite framework should include key risk indicators on sector and/or portfolio level, in order to effectively measure and steer on CRE and to support the transition to a low-carbon economy.
First, despite large banks hiring dedicated climate risk teams, the ECB is concerned that even these banks are underestimating the capacity and capabilities needed to integrate CRE risks comprehensively.
This reflects on the project-based nature of these climate risk teams. Furthermore, climate risk teams are often staffed with traditional banking experts, rather than sustainable finance experts or climate scientists.
Second, the ECB expects almost all banks to accelerate their efforts on CRE risk. The ECB specifically regrets the ‘wait and see’ approach that currently dominates the market. Therefore, banks should carefully consider the good practice paper supplementing the thematic review outcomes. This good practice paper should be read as an instruction manual for implementation, rather than an ideal state.
Third, many risk management teams have ongoing remediation programmes for their conventional risk management processes which takes time away from considering CRE risks at the level of detail required by the ECB. However, banks should see these ongoing efforts as an opportunity. When redeveloping a model, now is the perfect time to consider integrating CRE risk factors and collecting the required data. The ECB finds that 80% of banks now see CRE risk as a material risk.
Johan is acting as Financial Risk Management Lead within Deloitte’s Risk Advisory team in Finland. He has worked on financial risk related projects across the Nordics, Europe, the Middle East and Africa in an advisory and audit support capacity. The nature of his experience involves solving financial risk management problems for clients in the financial services sector. These problems include, but are not limited to, the interpretation and implementation of regulatory requirements related to financial risk across risk modelling, stress testing and capital management. As part of his role in the team, Johan leads the Financial Risk from Climate Change proposition in the Nordics.
Johanna toimii Senior Managerina Deloitten Regulatory Risk -tiimissä keskittyen erityisesti finanssisektoriin ja sääntelyriskeihin. Johannalla on yli 12 vuoden kokemus finanssipuolelta sekä vuosien kokemus rahoitusriskien ja kestävän rahoituksen konsultointipalveluista. In English Johanna is a Senior Manager in the Regulatory Risk practice in Deloitte Finland providing advisory services to clients in the Financial Services Industry. She has 12+ year of experience from the industry, and several years from the advisory services with specific focus on Financial risk and Sustainable finance topics. The nature of her role include leading complex regulatory or risk driven engagements and finding solutions for various risk management challenges.