ECB launches a public consultation on its guide on climate related and environmental risks

ECB public consultation on climate – related and environmental risks – at a glance

Who is concerned?

• The guidelines are aimed at European Institutions directly supervised by the ECB.
• The guidelines are expected to be applied also by less signficant/non-systemic institutions considering also the proportionality principle. 

Why it is important

• The guidelines are to be used in the supervisory dialogue (Supervisory Review and Evaluation Process  - SREP).

Timeline of application

• Implementation of the EBA mandates and ECB expectations is immediate and by the end 2020 institutions are expected to inform ECB of any divergence from them.

Summary of expectations

The guide captures ECB’s expectations with regards to the efficient and prudent management of climate change risks. Broadly, the expectations target the following core areas: 

• Business Model & Strategy
• Governance & Risk Appetite
• Risk Management
• Disclosures

The expected magnitude on each area is the depicted on the following dashboard:

Focus on Business Model, Risk Appetite and Financial Risk Management systems

Business Model & Strategy

ECB’s expectations guide institutions towards ensuring an safe and prudent management framework of their climate-related risks. Hence, it is important for institutions to adequately identify and address the impact of climate change risks on their business environment and ensure the resilience of their business model.

Business Environment

Institutions are expected to understand the impact of climate-related and environmental risks on the business environment in which they operate, in the short, medium and long term, in order to be able to make informed strategic and business decisions.

Business Strategy

When determining and implementing their business strategy, institutions are expected to integrate climate-related and environmental risks that materially impact their business environment in the short, medium or long term.

• ECB expects institutions to determine which climate-related and environmental risks are material in the short, medium and long term with regard to their business strategy, for example by using (stress) scenario analyses.
• The implementation of the institution’s business strategy is expected to reflect material climate-related and environmental risks, for example by setting and monitoring key performance indicators (KPIs) that are cascaded down to individual business lines and portfolios.

ECB observations: Climate-oriented KPIs

The ECB observed an institution which had integrated the following climate-related and environmental key performance indicators (KPIs) into its strategic framework with a view to making its strategy measurable: 

• The carbon emission footprint of its assets.
• The average energy label of its mortgage portfolios.
• The number of homes that saw an energy label improvement thanks to its financing.
• The share of assets under management that was invested according to a predefined green investment mandate. 

These KPIs underpin the bank’s strategic approach to climate change and other environmental developments. These metrics are cascaded down to the business line level (e.g. retail banking, private banking, commercial banking and corporate banking). For each metric, the respective time horizon is set and progress is measured against a base year.

Governance and Risk Appetite

Institutions are expected to have robust governance arrangements in place that allow institutions to effectively identify, manage, monitor and report the risks they are or might be exposed to, so as to form a holistic view of all risks both on an individual and consolidated basis.

Governance

Governance and control systems are key to stakeholders’ understanding of the robustness of an institution’s approach to climate-related issues. Information on the involvement of the board and management, in particular their respective responsibilities in relation to climate change, informs stakeholders on the level of the company’s awareness of climate-related issues. When describing the role of the board, the Institution may wish to make a reference to any corporate governance statement that it is required to publish.

Risk Appetite

Institutions are expected to have in place a risk appetite framework (RAF) that considers all the material risks to which the institution is exposed, that is forward-looking, in line with the strategic planning horizon set out in the business strategy and that is reviewed regularly. Integrating climate-related and environmental risks into the RAF increases institutions’ resilience to such risks and improves their ability to manage those risks, for example, by setting limits on lending to sectors and geographies that are highly exposed to climate-related or environmental risks.

Specifically, institutions are expected to explicitly include climate-related and environmental risks in their risk appetite framework.

• Institutions are expected to develop a well-defined description of climate-related and environmental risks in their risk appetite statement.
• Institutions are expected to develop appropriate key risk indicators and set appropriate limits for climate-related and environmental risks in line with their regular monitoring and escalation arrangements.
• Institutions are expected to ensure that their remuneration policy and practices stimulate behavior consistent with their climate-related and environmental (risk) approach, as well as with voluntarily commitments made by the institution.

ECB observations

Risk Appetite: Carbon intensity targeting and climate resilience of the balance sheet

The ECB observed that several institutions aim to keep the carbon content of their financed energy mix in line with the target of remaining well below 2°C as provided for in the Paris Agreement (2015).

Some institutions use the International Energy Agency (IEA) Sustainable Development Scenario or a similar scenario to quantify such targets, as illustrated in the graph. Other institutions take a different approach that involves, for each sector with a large carbon footprint, measuring and benchmarking how lending to these sectors contributes to climate resilience, and adjusting the lending portfolio accordingly. Such approaches are not mutually exclusive and, in fact, some institutions have adopted several methodologies.

Management Bodies: Climate change risk dedicated committees

The ECB observed several institutions that established dedicated committees as part of their efforts to fully consider climate-related and environmental risks. For example, as part of its medium-term strategic plan, one bank is in the process of establishing a committee which draws on internal and external expertise, such as scientists from relevant disciplines, to advise and assist the management body in defining its ESG strategy. This includes reviewing its climate-related and environmental risks, as well as related sectoral financing policies, which determine both targets and limits for exposures to certain sectors. Another bank has set up a dedicated committee to provide informed guidance on transactions with complex climate-related and environmental implications. This committee is chaired by senior management.

Organizational Structure: Points of contact

The ECB observed several institutions that implemented specific measures to promote a risk culture that takes into account climate-related and environmental risks. For example, one bank designated horizontal points of contact to ensure that climate-related and environmental risks were appropriately integrated into its risk management function’s working procedures. Another bank put in place correspondents for those business lines actively cooperating and liaising with risk management functions and/or other functions involved in ESG risks, including climate-related and environmental risks.

Relating to risk management framework and systems

ECB’s guideline provides a thorough roadmap on integrating climate-related and environmental risks into credit, operational, market and liquidity risk management, as well as into the ICAAP, including risk quantification by means of scenario analysis and stress testing.

Risk Management Framework

Institutions are expected to incorporate climate-related and environmental risks as drivers of established risk categories into their existing risk management framework, with a view to managing and monitoring these over a sufficiently long-term horizon, and to review their arrangements on a regular basis. Institutions are expected to identify and quantify these risks within their overall process of ensuring capital adequacy.

• Institutions are expected to have a holistic and well-documented view of the impact of climate-related and environmental risks on existing risk categories.
• Institutions are expected to adequately quantify the climate-related and environmental risks that the institution is exposed to.
• Institutions are expected to adopt a strategic approach to managing and/or mitigating climate-related and environmental risks in line with their business strategy and risk appetite, and to adapt policies, procedures, risk limits and risk controls accordingly.
• Institutions are expected to conduct a proper climate-related and environmental due diligence, both at the inception of a client relationship and on an ongoing basis.
• Institutions are expected to assess the impact of climate-related and environmental risks on their capital adequacy from an economic and a normative perspective.
• Institutions are expected to evaluate the appropriateness of their identification, measurement and mitigation instruments for climate-related and environmental risks in their periodic reviews.

ECB observations

Mapping climate change risk to financial risks

Some institutions have launched an internal process to map climate-related risks and their potential financial impacts. One bank mapped the main transmission channels onto existing risk categories and provided an overview of the estimated impact on its risk profile as well as the estimated time frame.

Quantifying climate-related impacts to financing in ICAAP

The ECB has observed a bank that, in its internal capital plan, assesses the environmental impact of its financing and assigns an environmental rating to either the asset or project being financed, or to the borrower for general purpose financing, whether a corporate or public sector client. This rating is derived from an assessment of the deal’s climate impact, and factors in any significant environmental externalities, such as water use, pollution, waste and biodiversity. On the basis of this rating, the bank applies penalties to the assets projected to have the highest level of environmental impact, leading to an increase in the analytical risk weight for these exposures. The bank reports that the facilities with a negative environmental and climate impact are subject to an increase in their analytical risk-weighted assets of up to a quarter. Ultimately, this impact is reflected in the expected rate of return of the assets, providing potential incentives to invest or disinvest in particular sectors.

Credit Risk Management

In their credit risk management, institutions are expected to consider climate-related and environmental risks at all stages of the credit-granting process and to monitor the risks in their portfolios.

• Climate-related and environmental risks are expected to be included in all relevant stages of the credit-granting process and credit processing.
• Institutions are expected to adjust risk classification procedures in order to identify and evaluate, at least qualitatively, climate-related and environmental risks.
• Institutions are expected to consider climate-related and environmental risks in their collateral valuations.
• Institutions are expected to monitor and manage credit risks in their portfolios, for example, through sectoral/geographic concentrations analysis, exposure limits, deleveraging strategies and scenario-analysis and/or stress testing.
• Institutions’ loan pricing frameworks are expected to reflect their credit risk appetite and business strategy with regard to climate-related and environmental factors.
• Institutions’ loan pricing is expected to reflect the different costs driven by climate-related and environmental risks.

Operational Risk Management

In their Operational Risk Management, Institutions are expected to consider how climate-related events could have an adverse impact on business continuity and the extent to which the nature of institutions’ activities could increase reputational and/or liability risks. 

• Institutions are expected to assess the impact of physical risks on their operations in general, including the ability to quickly recover their capacity to continue providing services.
• Institutions are expected to consider the extent to which the nature of the activities in which they are involved increases the risk of future reputational damage or liability.

ECB observations

Shadow PDs and climate-related factors

The ECB observed that institutions often consider climate-related and environmental risks qualitatively in their credit-granting process. Nonetheless, some institutions are considering or in the process of developing means to incorporate these risks into their models. One bank is developing climate-informed shadow probabilities of defaults (PDs) to be reported alongside the regular PDs. The climate-informed shadow PDs would take into consideration a detailed analysis of physical and transition risks for higher risk counterparties identified in a screening process. A big differential between the two would then trigger the need to consider mitigating action. A second bank is developing a scorecard for sustainability risks comprising qualitative aspects. The input from the scorecard would get a fixed weighting within the model. Another bank includes environmental variables in its internal credit-scoring models. The environmental valuation has been introduced for sectors where such an assessment was found to be relevant in terms of credit quality differential analysis. The potential environmental impact of the underlying activities influences the credit quality. The credit-scoring models have been rolled out for exposures to large corporates, corporates and for project finance exposures.

Mortgage price differentiation

The ECB observed an institution that differentiates the client price of retail mortgage loans according to the energy label of the underlying real estate. Mortgages with a better energy label receive a lower client rate than mortgages with a less energy-efficient label, while the institution’s overall profitability target for mortgages is projected to be met. This price differentiation is in line with its strategy to support sustainable banking. In addition, a portfolio with higher energy-efficiency labels is likely to be less vulnerable to transition risk. As a result, the mortgage portfolio shifts to a portfolio with a better energy-label distribution.

Scenario Analysis & Stress Testing

Institutions with material climate-related and environmental risks are expected to evaluate the appropriateness of their stress testing with a view to incorporating them into their baseline and adverse scenarios.

When conducting scenario analysis and stress testing with respect to climate-related and environmental risks, at least the following aspects are expected to be considered:

• How the institution might be affected by physical risk and transition risk.
• How climate-related and environmental risks might evolve under various scenarios, taking into account that these risks may not be fully reflected in historical data.
• How climate-related and environmental risks might materialize in the short, medium and long term depending on the scenarios considered.

Institutions are expected to consider several scenarios based on different combinations of assumptions. Specifically, for the adverse scenarios, institutions are expected to assume unusual but plausible developments with an adequate degree of severity in terms of their impact on their regulatory capital ratios. As part of their capital planning, institutions are expected to assess their capital adequacy under a credible baseline scenario and institution-specific adverse scenarios. 

Market & Liquidity Risk Management

Institutions are encouraged to monitor, on an ongoing basis, the effect of climate-related and environmental factors on their current market risk positions and future investments, and to develop stress-testing scenarios that incorporate climate-related and environmental risks.

Furthermore, institutions are expected to assess whether material climate-related and environmental risks could cause net cash outflows or depletion of liquidity buffers and, if so, incorporate these factors into their liquidity risk management and liquidity buffer calibration.

Disclosures

Climate-related information should, to the extent necessary, include both the principal risks to the development, performance and position of the company resulting from climate change, and the principal risks of a negative impact on the climate resulting from the company’s activities. The proposed disclosures in these guidelines reflect both these risk perspectives.

References to risks should be understood to refer both to risks of negative impacts on the company and risks of negative impacts on the climate, unless it is stated otherwise in the text. Both of these types of risk may arise from the Institutions own operations and may occur throughout the value chain, both upstream in the supply chain and downstream.

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Risk

• Identifying, quantifying, managing and responding to latent and emerging ESG risk. 
• Integrating ESG (and particularly climate) capabilities into existing risk frameworks. 
• Enhancing existing risk modelling and stress testing capabilities, for climate change.

Internal Audit

• Setting appropriate audit programmes to focus on material risks to firms’ climate risk identification and management. 
• Developing expertise to constructively challenge, and add-value to firms’ climate risk and sustainable finance programmes of work. 

Sustainability

• Helping organizations find focus on ESG sustainable finance. 
• Designing sustainable finance programmes which add-value, deliver positive impact, and support delivery of strategic objectives. 

Strategy

• Shaping innovative and brand-enhancing sustainable finance strategies, which successfully capture (and even create) attractive market demand. 
• Designing future-proofed strategies which meet the evolving needs of clients, and deliver competitive advantage though ESG- creating sustainable value, and driving the low carbon transition. 

Compliance

• Maintaining currency with the rapidly evolving, and complex, regulatory climate risk and sustainable finance landscape. 
• Preserving the integrity of businesses control frameworks to support compliance around climate risk and sustainable finance requirements. 

Finance

• Incorporating climate-related financial risks into pricing, forecasting and budgeting, financial reporting, and capital-allocation.
• Accounting for climate risks requires updates to the implementation of existing standards, e.g. liabilities under insurance contracts (IFRS 17), or in the impairment of assets (IFRS 9). 

Legal

• Understanding and managing liability risks from climate change – from inadequate, or inaccurate disclosure of material financial risks. 
• Interpreting the credibility and transparency of sustainable finance products, in the context of the risk of ‘green’ and ‘impact-washing’, and resultant mis-selling implications. 

Front Office

• Identifying client, counterparty and transactional ESG risks, and integrating these into investment, underwriting, and lending decision-making. 
• Understanding customers ESG preferences, and incorporating into these into the sale of products, and provision of advice, in a rapidly-developing regulatory environment. 

Procurement & HR

• Managing supply chain ESG risks, and ensuring firms do business with suppliers with consistent values and standards. 
• Managing workforce risk from climate change – to the firm (e.g. resilience, migration, expertise, engagement), and to employees (e.g. health, migration). 

Communications

• Communicating credibly and effectively to the market the sustainability of firms operations and financing, its ESG impacts, and the resilience of its strategy to climate change. 
• Providing transparency over firms’ product offering to avoid risks from green and impact washing.