Lessons learned from the ECB climate risk stress test

Embed climate risk within the risk management and stress testing framework

Only approximately 40% of the in-scope banks included climate risk into their regular Internal Capital Adequacy Assessment Process (ICAAP) and stress testing framework. The other 60% of the banks expects that it will take 1 to 3 years to integrate climate within the stress testing framework. The first step for banks is to integrate climate risk in the risk materiality assessment process as part of the ICAAP. Furthermore banks need to start sandboxing to explore new modelling approaches to include climate factors in credit risk models. In addition, banks can enhance the risk appetite framework by including climate risk indicators, at firm level as well as on sector and portfolio level, in order to effectively measure and steer on climate change related risk. Also, the collection and assessment of counterparties’ transition plans should be embedded into the loan origination and monitoring process to obtain insights in the ability to mitigate transition risk. 

Improve the data availability

The European Central Bank (ECB) highlighted that having accurate data is key in developing a solid stress testing framework.  Banks face challenges collecting data with respect to Energy Performance Certificates (EPC), collateral locations and the Scope 1, 2 and 3 emissions. Banks can enhance the climate risk data availability by developing an approach to structurally embed climate risk data in the organization, including the data governance, the definition of data requirements, the data sourcing process and the data quality procedures. The first step is to prepare a climate risk data catalogue with data elements required for climate risk management and disclosures purposes, beyond stress testing including relevant regulations. In addition if banks keep relying on proxies for certain data elements, the methodology of applying proxies should be improved and better documented. 

Further enhance the modelling capabilities

Banks were allowed to apply a dynamic balance sheet assumption as part of the 30 years transition risk scenarios, in order to adapt the strategy and portfolio of banks to the changing climate and economic environment. However, only 22% of the banks considered a dynamic balance sheet for modelling transition risk. Banks did not differentiate enough in the projections of loan losses and balance sheet allocation (e.g., decrease in allocation to carbon-intensive industries over time) between the three climate scenarios (i.e., orderly transition, disorderly transition and hot house world). Banks should start to develop the capability to differentiate in portfolio allocation in long term projections. Sector experts can play an important role in understanding possible developments of portfolios under different climate scenarios. This portfolio allocation process can be further accelerated by translating a bank’s sustainability strategy into estimates of required carbon reduction over time, and preferably also per sector. This will support the development of a methodology than can fully capture climate risk on a long term horizon of for example 30 years.

Right now is the time to act: banks should fully embed climate in the regular risk management and stress testing framework, improve the data collection process and further develop the climate risk modelling capabilities. Please feel free to reach out and we can discuss how to overcome your organization specific challenges. 

The attachment linked to this blog further explores these challenges with specific recommendations.