פורסם: 20/10/2020, הפוסט עודכן בתאריך: 17/4/2021.
המסמך שלהלן מובא כחלק מנסיון לברר היכן עומדים הרגולטורים הישראלים המפקחים על הגופים הפיננסיים (במיוחד אלו שמפקחים על הגופים המוסדיים, קרנות הפנסיה וקופות הגמל ועל הבנקים) ביחס לרגולטורים האירופאים בנושאים הקשורים להתחממות הגלובלית ולמשבר האקלים וזאת לאחר שהרגולטורים הישראלים החלו להתייחס לנושא מול הגופים המפוקחים (בהתייחס לגופים המוסדיים ראו טיוטת תיקון חוזר “ניהול נכסי השקעה” (שיקולי השקעה הנוגעים להיבטים סביבתיים, חברתיים והיבטי ממשל תאגידי); וביחס לבנקים ראו מכתב המפקח על הבנקים לתאגידים הבנקאיים וחברות כרטיסי אשראי – הנדון: ניהול סיכונים סביבתיים).
המסמך המפורט של רשות ה-EBA מראה שהרגולטור האירופי מבין את סיכוני האקלים וכי הוא עושה מאמץ להנגיש את המידע לגופים המפוקחים.
חשוב: נייר העמדה המובא להלן הינו העתק חלקי של נייר העמדה המקורי. הוא מתמקד בסגמנט הסביבתי של נייר העמדה (ה-“E” מתוך ESG). הטקסט המסומן בהטיה ובקו תחתון מהווה את עיקרי הדברים החשובים המצויים בו.
The EBA is part of the European System of Financial Supervision together with two other supervisory authorities
Published on 20/10/2020
Important: This article is a partial copy of the original EBA paper. This article focuses on the Environmental segment of the ESG (The “E”).
ESG factors materialise at many levels, such as international, country, sectoral or entity level. This discussion paper includes proposals for common definitions of ESG risks to credit institutions and investment firms (hereafter institutions) as risks that stem from the current or prospective impacts of ESG factors on its counterparties. Therefore, the financial materiality of ESG risks will need to be carefully assessed by institutions and supervisors. Since not all financing activities are likely to be equally affected by ESG risks, it is important that institutions and supervisors are able to distinguish and form a view on the relevance of ESG risks, following a proportionate, risk-based approach that takes into account the likelihood and the severity of the materialisation of ESG risks.
The main focus of this discussion paper is on the risks to which the institutions are exposed to via the impact of ESG factors on its counterparties.
In the discussion paper ESG factors and ESG risks are identified and explained, giving particular consideration to risks stemming from environmental factors and especially climate change, reflecting ongoing initiatives and progress achieved by institutions and supervisors on this particular topic over the recent years
The EBA sees the need for enhancing the incorporation of ESG risks into institutions’ business strategies, business processes and proportionately incorporate ESG risks in their internal governance arrangements. The EBA also sees a need to gradually develop methodologies and approaches to a climate risk stress test
discussion paper is closely linked with, and leverages on, the work done by other stakeholders, either policy-makers, central banks and the supervisory community, think-tanks, researches and industry initiatives.
In 2015, more than 190 governments around the world adopted the UN 2030 Agenda for Sustainable Development, aiming to support further progress on a wide range of many interconnected and cross-cutting economic, social and environmental objectives.
Also in 2015, signatories to the Paris Agreement committed to undertake ambitious efforts to limit the increase in the global average temperature to well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5° above such levels. This implies the need for early actions to reach peaking of greenhouse gas emissions as soon as possible and to undertake rapid reductions thereafter. In the long term, an unabated warming pathway would lead to significant declines in global GDP by 2100
The European Commission’s Action Plan has the following three main objectives:
a. reorienting capital flows towards sustainable investment in order to achieve sustainable and inclusive growth;
b. managing financial risks stemming from climate change, resource depletion, environmental degradation and social issues and;
c. fostering transparency and long-termism in financial and economic activity, and is complemented with broader legislative efforts to support the transition to a more sustainable global economy.
The financial sector is expected to play a key role in financing the transition of the economy to a more sustainable form. According to the EU Commission’s “Action Plan – Financing Sustainable Growth”, the financial system is being reformed to address the lessons of the financial crisis, and, in this context, it could be part of the solution towards a greener and more sustainable economy. Reorienting private capital to more sustainable investments was said to require a comprehensive shift in how the financial system works. This transformation will certainly spur new business opportunities, but the financial sector will also experience the financial risks stemming from the transformation of the economy and the worsening physical conditions.
The EBA report shall comprise at least the following:
a. a definition of ESG risks, including physical risks and transition risks related to the transition to a more sustainable economy, and, with regard to transition risks, including risks related to the depreciation of assets due to regulatory change, qualitative and quantitative criteria and metrics relevant for assessing such risks, as well as a methodology for assessing the possibility of such risks arising in the short, medium, or long term and the possibility of such risks having a material financial impact on an investment firm;
b. an assessment of the possibility of significant concentrations of specific assets increasing ESG risks, including physical risks and transition risks for an investment firm;
c. a description of the processes by means of which an investment firm can identify, assess, and manage ESG risks, including physical risks and transition risks;
d. the criteria, parameters and metrics by means of which supervisors and investment firms can assess the impact of short‐, medium‐ and long‐term ESG risks for the purposes of the supervisory review and evaluation process.
The impact of ESG risks materialises in the form of existing prudential risks (e.g. credit risk, market risk, operational risk).
Generally, references to ESG factors are associated with the concept of sustainable finance, sometimes also referred to as green finance. Specifically, sustainable finance relates to financing to ‘support economic growth while reducing pressures on the environment and taking into account social and governance aspects. Sustainable finance also encompasses transparency on risks related to ESG factors that may impact the financial system, and the mitigation of such risks through the appropriate governance of financial and corporate actors’.
Examples of ESG factors that are common across those definitions and practices for financial and non-financial firms include greenhouse gas emissions, biodiversity and water use and consumption in the area of environment
Negative economic externalities: ESG factors such as pollution, overall welfare of the society, poverty, are of particular concern to the wider public. While they reflect the impact of a sum of individual activities, they are not captured in financial statements, meaning that the costs of those activities is borne by third parties or by the society at large and not fully captured by market mechanisms. For example, consider the ‘collective’ cost of greenhouse gas emissions generated by an entity. In the absence of carbon pricing that adequately captures climate related externalities, financial markets, while seemingly willing to price climate risk, are unable to fully reflect this risk in prices.
Patterns arising from the value chain: Patterns arising throughout the value chain mean the impacts from an entity’s activities and interactions with different stakeholders within its upstream and downstream value chains. In the context of these activities, an entity may face indirectly through its debtors and creditors different ESG factors.
Increased sensitivity to changes in public policies designed to mitigate climate change and other externalities: Signatories of SDGs and the Paris Agreement have committed to undertake ambitious efforts in meeting the set goals and targets, which imply major changes in public policies and regulatory framework. Efforts to limit climate change might imply significant regulatory shifts and lead into wider structural changes difficult to include into economic development predictions.
Example of public policies designed to mitigate climate change For example, at the European level, the EU’s Emissions Trading System (EU ETS) is key for the EU policy to tackle climate change and for a cost-effective reduction of emissions of carbon dioxide (CO2) and other greenhouse gases (GHG) in the power, aviation and industrial sectors. It was launched in 2005 and is the first – and still the largest – international system for trading GHG allowances covering over three-quarters of the allowances traded on the international carbon market, while it covers around 45% of the EU’s GHG emissions. Another example is at national level, where the German legislator has adopted a law introducing a national emissions trading scheme for trading heating oil, natural gas, petrol and diesel. These mechanisms will significantly increase the price of fossil fuels in the construction and transport sectors and strain the profitability of corporates active in those sectors that are particularly dependent on fossil fuels.
The main purpose of this discussion paper is to define and develop assessment criteria for ESG factors that may impact the financial performance and solvency of institutions via their counterparties. For instance, an institution may experience a negative financial impact when it holds collateral assets that become stranded assets due to the introduction of regulatory changes aimed at containing climate change.
For the purpose of this paper, the ESG factors can be defined in the following way: ‘ESG factors are environmental, social or governance characteristics that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual.’
As referred to in the definition of the ESG factors, the ESG factors can have negative or positive impacts. From this perspective the ESG factors can be used also when evaluating opportunities for financial or non-financial entities related to the transition to more sustainable economy.
ESG risks materialise when the ESG factors affecting institutions’ counterparties have a negative impact on the financial performance or solvency of such institutions.
The materiality of ESG risks depends on the risks posed by ESG factors over the short, medium and long-term. In this regard, double materiality perspective in terms of the impact that the counterparty’s activities can have on the institutions’ performance can be identified and includes both:
a. financial materiality, which may arise from such economic and financial activities throughout their entire value chain, both upstream and downstream, affecting the value (returns) of such activities and therefore typically of most interest to institutions; and
b. environmental and social materiality, stemming from the external impact of those economic and financial activities, typically of most interest to citizens, consumers, employees, business partners, civil society organisations and communities.
When assessing financial materiality, it is also important to distinguish between impacts that are exogenous to the counterparty’s activities (e.g., floods, tsunamis, fires or other climate-related hazards) and impacts that originate from the counterparty’s activities (e.g. any activity that may be considered as damaging for the climate such as CO2 emissions or use of fossil fuels, and/or as a failure to comply with social standards, like labour conditions, and ethical values). Hence, managing ESG risks implies taking into account both types of materiality and the two potential originations of the impacts from ESG factors.
‘ESG risks mean the risks of any negative financial impact to the institution stemming from the current or prospective impacts of ESG factors on its counterparties’
Environmental factors are related to the quality and functioning of the natural environment and systems, which may have an impact on the activities of the institutions’ counterparties. The main transmission channels for the impact of environmental factors cover physical (such as extreme weather events and gradually deteriorating conditions in climate) and transition (such as regulatory restrictions or taxation, disruptive technologies and changing consumer preferences) transmission channels. These channels can affect the entire value chain of companies as well as any other counterparties to which institutions are exposed.
The impact of environmental factors can be twofold, reflecting their potential double materiality. On the one hand, the financial performance of a counterparty can be affected by environmental factors, for example, the introduction of a carbon tax may decrease the profitability of carbon-dependent businesses or decrease the competitiveness of their products. On the other hand, the activities of the counterparties may have a negative impact on the environment, e.g., via the release of a large volume of CO2 into the atmosphere, leading to an environmental materiality, which may trigger a financial impact on such counterparties.
Environmental risks are driven by environmental factors. They should be understood as the financial risks posed by the institutions’ exposures to counterparties that may potentially contribute to or be affected by climate change and other forms of environmental degradation (such as air pollution, water pollution, scarcity of fresh water, land contamination, biodiversity loss and deforestation).
Climate-related risks are the financial risks posed by the exposure of institutions to counterparties that may potentially contribute to or be affected by climate change. For example, damage for companies or citizens caused by extreme weather events or a decline of asset value of a company in carbon-intensive sectors.
There is a connection and to some degree an overlap between climate-related and environmental risks. Climate change also leads to environmental degradation, as an increase of just 1.5°C is already expected to have a significant impact on biodiversity and ecosystems on land and in the sea. Yet, not all environmental degradation is a result of climate change as it can stem from other sources as well. For example, rising population levels and income growth leading to higher water demand will cause a large part of the world and its inhabitants to face water stress.
Climate-related and other environmental risk cannot be entirely separated, as they may reinforce each other given that climate change could increase the degradation of the environment and vice versa. For example, reductions in the diversity of cultivated crops due to the rise in temperatures may mean that agroecosystems are less resilient against future climate change, pests and pathogens. At the same time, healthy ecosystems contribute to resilience and adapting to conditions caused by climate change that are already taking place, such as higher temperatures, rising seas, fiercer storms, more unpredictable rainfall and more acidic oceans.
Therefore, the scope of the analysis presented in this discussion paper covers a definition of environmental risks that includes the impact of both climate-change and other environmental factors. For the purpose of this report ‘Environmental risks are the risks posed by the exposure of institutions to counterparties that may potentially be negatively affected by environmental factors, including factors resulting from the climate change and factors resulting from other environmental degradation.’
Environmental risks can materialise via the three main transmission channels:
a. Physical transmission channels
b. Transition transmission channels
c. Liability transmission channels (see section 4.6)
Although definitions of physical risks vary marginally among international organisations, central banks, supervisors, policy-makers and researchers, they are typically defined as one of the transmission channels through which climate-related risks (including shocks) can materialise, impacting negatively the financial position of counterparties and, hence, potentially causing the depreciation of assets.
For example, the ‘Guidelines on non-financial reporting: Supplement on reporting climate-related information’ issued by the European Commission define physical risks as ‘risks to the company that arise from physical effects of climate change. They include:
a. acute physical risks, which arise from particular events, especially weather-related events such as storms, floods, fires or heatwaves, that may damage production facilities and disrupt value chains;
b. chronic physical risks, which arise from longer-term changes in the climate, such as temperature changes, rising sea levels, reduced water availability, biodiversity loss and changes in land and soil productivity’.
So far, physical risks have been mainly defined as the impact or the transmission channels of climate change. However, there are environmental events other than climate change that can drive physical risks as well, such as water stress, biodiversity loss and pollution (see Box 3).
Figure 3 illustrates a cycle on how environmental factors (e.g. biodiversity loss and lack of healthy ecosystems) can manifest in environmental risk through the physical risk transmission channel and then have an impact on institutions’ balance sheet.
In this example, biodiversity loss impacts the risk profile of an institution’s counterparty, through the physical impact of a reduction in agricultural activities and food production. The physical impact transmits onto the balance sheet of an institution exposed to the agricultural sector, increasing its risk profile.
Considering the existing definitions of physical risks in the context of climate change, the EBA would extend this to environmental risks, defined as follows: Physical transmission channels/physical risks are the risks posed by the exposure of institutions to counterparties that may potentially be negatively affected by the physical effects of climate change or other environmental factors, including:
a. acute physical effects, which arise from particular events, especially weather-related events such as storms, floods, fires or heatwaves, that may damage production facilities and disrupt value chains; and
b. chronic physical effects, which arise from longer-term trends, such as temperature changes, rising sea levels, reduced water availability, biodiversity loss and changes in land and soil productivity.
Transition risks are the other main transmission channel through which climate change may impact the financial position of the institution’s counterparties negatively. Although definitions vary across different sources, transition risks generally refer to the uncertainty related to the timing and speed of the process of adjustment towards a low-carbon economy.
Such process will be affected, for instance, by the impact of the related policy action on the asset prices of carbon-intensive sectors and/or by physical risks themselves, and includes the risks of potentially disordered mitigation strategies. In addition, technological changes may, for instance, make existing technologies obsolete or could allow today’s comparatively less sustainable activities to become more environmentally friendly in the future. Such technological progress, if materialised, might trigger a repricing of assets that is difficult to foresee. Changes in the preferences and behaviour of consumers, investors and entities may also affect the relevance of ESG factors over time. As an example, a change in the preferences of customers (such as avoidance of investing in non-sustainable assets) may impact institutions’ investment product offerings.
The NGFS (Network for Greening the Financial System) defines transition risks as financial risks which can result from the process of adjustment towards a lower-carbon and more circular economy, prompted, for example, by changes in climate and environmental policy, technology or market sentiment.
The NGFS identifies three main categories of transition risk drivers in the context of climate risk:
a. Climate-related mitigation policies, which could lead to reductions in financial valuations and/or downgrades in credit ratings for companies not compliant with such policies because they no longer earn an economic return on past investment;
b. Technological advances, which could affect the relative pricing of alternative products and reduce the market shares of certain companies, resulting in lower profitability and eventually losses for institutions; and
c. Shift in public sentiment, demand patterns, and preferences and expectations that can affect the economy and the financial system.
In the European Commission’s ‘Guidelines on non-financial reporting: Supplement on reporting climate-related information’, transition risks (in the context of climate risk) are defined as ‘risks to the company that arise from the transition to a low-carbon and climate-resilient economy. They include:
a. Policy risks, for example as a result of energy efficiency requirements, carbon-pricing mechanisms which increase the price of fossil fuels, or policies to encourage sustainable land use.
b. Legal risks, for example the risk of litigation for failing to avoid or minimise adverse impacts on the climate, or failing to adapt to climate change.
c. Technology risks, for example if a technology with a less damaging impact on the climate replaces a technology that is more damaging to the climate.
d. Market risks, for example if the choices of consumers and business customers shift towards products and services that are less damaging to the climate.
e. Reputational risks, for example the difficulty of attracting and retaining customers, employees, business partners and investors if a company has reputation for damaging the climate.’
Another definition has been used by the TCFD (Task Force on Climate-related Financial Disclosure) in the context of climate risk, which identifies similar risk drivers, however grouped in four different categories: i) policy and legal risk, ii) technology risk, iii) market risk and iv) reputation risk.
Legal risks in the context of climate-change – sometimes also referred as liability risks or litigation risks – are often considered as a separate risk category and refer to the “the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible”. Legal risks are sometimes considered as part of either physical or transition risks, and are, in principle, more likely to impact on institutions that are active in the liability insurance market.
Transition risks can also impact individuals, for example, when they are employed by a carbon-intensive company that fails due to new carbon pricing mechanisms, and sovereigns, for example, when the transition causes mass unemployment and therefore a deterioration of tax income or increased public spending. They can also lower the value of collateral which does not meet the latest environmental standards or market expectations anymore.
Figure 4 illustrates that regulatory intervention to tackle carbon emissions can create transition risk for the economic agents, and manifest as the counterparty risk on the institution’s balance sheet.
Such transition to a low carbon and climate-resilient economy, as mentioned above, can also provide opportunities for the counterparties -and the institutions providing funding to them – if companies contribute to climate mitigation and adaptation.
Similarly to the definition of physical risks, the existing definitions of transition risks are used primarily in the context of climate change. However, it can be easily expanded beyond climate change, e.g. to water stress and biodiversity loss, to cover all aspects of environmental risks (see Box 4).
In the case of water stress, policy risk bringing in regulatory changes may incentivise re-channelling of capital (and water) from less essential sectors and business activities (such as clothing industry) to more essential sectors and business activities (such as agriculture), affecting ongoing business operations of companies. Similarly, consumer behaviour and preferences as well as technological development may shift towards more water efficient practices.
Biodiversity loss can lead to policy risk when governments introduce measures to counter, for example, deforestation, use of fertilisers or excessive land use, which would then impact the value of businesses relaying on those lands or practices, or strict regulation in agriculture and fisheries affecting the outcome from those activities. Similarly, change in consumer dynamics and technology may shift practices towards more sustainable path ways to safeguard biodiversity.
Considering the existing definitions and main drivers of transition risks, the following definition, extended to overall environmental risks, is proposed. Transition transmission channels/transition risks are the risks posed by the exposure of institutions to counterparties that may potentially be negatively affected by the transition to a low-carbon, climate-resilient or environmentally sustainable economy, including:
Transition and physical risks interact closely with each other and companies and institutions may be subject to the full impact of these risks.
The persistent emissions of greenhouse gases without carbon removal technologies in place and the continuation of unsustainable practices in the economy contribute to the very source of physical risks, potentially exacerbating the likelihood of environmental hazards and its socio-economic impacts.
As a response to the impact of physical risks, policy makers will likely introduce, where not already in place, mitigation policies and regulation; people’s preferences may also change towards more sustainable products and services. As a result, the negative impact of both physical risks and transition risks is more likely to materialise. For example, an institution might be exposed to counterparties that go bankrupt due to the introduction of climate mitigation policies, while at the same time assets held as collateral are damaged during a flood incident.
In addition, depending on their scale, physical and transition risks have the potential to trigger significant impacts on the real economy and the financial system as a whole. These impacts may result from natural disasters and other environmental hazards and from the policies implemented in order to prevent or moderate the deterioration of the environment and climate change. As an illustrative example, continued environmental deterioration will impact the aggregate output levels as well as potential growth rates, as some economic activities become unviable or labour conditions deteriorate due to health issues. This could be the case, for instance, when rising temperatures and changing patterns of precipitation directly impact industries, such as agriculture and fisheries, energy, tourism, and construction among others. The relative adjustment of prices in the economy that will need to take place may create additional disruptive effects and further exacerbate the level of uncertainty, potentially increasing social unrest, as the impact of physical and transition risks is likely to be unevenly distributed across populations. Ultimately, further global warming could impact the solvency of sovereigns whose economies are heavily dependent on sectors vulnerable to climatic changes, such as agriculture or the tourism sector. While such significant macroeconomic impacts may occur in the more distant future, some impacts are already evident.
Social factors are related to the rights, well-being and interests of people and communities, which may have an impact on the activities of the institutions’ counterparties. Social factors, such as (in)equality, health, inclusiveness, labour relations, and investing in human capital and communities, are increasingly being considered in the business strategies and the operating frameworks of businesses, institutions and their counterparties.
Environmental and social risks are closely interrelated (see Box 5). The continuous deterioration of environmental conditions implies heightened social risks, such as when climate-related physical change or water stress affect deprived parts of a geographical area and already disadvantaged populations. Environmental degradation can exacerbate migration, social and political unrest in the most affected regions, with potentially more devastating repercussions and contagion across the globe. According to the Internal Displacement Monitoring Centre, between 2008 and 2018, natural disasters displaced as many as 265 million people. The World Bank projects that by 2050, lower water availability and crop productivity combined with the impact of other physical risks like storms or rising sea levels may lead 140 million people to migrate within their countries in Latin America, South Asia, and sub-Saharan Africa. While global warming should not be held solely responsible for migration decisions, it may amplify existing motivations such as income inequality, lack of human rights or civil wars. Another example of the interconnection between environmental and social risks is the potential impact that envisaged technological and regulatory changes to combat climate change may have on labour markets, for instance, amplifying social risks, particularly for (non-green) industries where low-skilled labour is prominent, e.g., the coal mining industry. The timing for the potential manifestation of these social risks is uncertain.
The outbreak of the COVID-19 pandemic provides a good example of the interaction between environmental, social and governance factors. Several commentators have highlighted the importance of biodiversity loss in the origin and spread of new diseases with several health and social impacts.
For the purpose of this discussion paper, “Social risks are the risks posed by the exposure of institutions to counterparties that may potentially be negatively affected by social factors.”
Governance plays also a fundamental role in ensuring the inclusion of environmental and social considerations by a given counterparty. Recognition of the potential impact of climate and environmental changes and related physical, transition and liability risks is understood as a sign of good governance. To the contrary, neglecting these potential impacts in the strategic planning of a counterparty may create additional governance risks.
There can also be a correlation between poor environmental performance and poor governance as evidenced by the Diesel emissions scandal. A small number of car manufacturers had declared for years lower-than-real nitrogen oxide emissions to the licensing authorities and their customers. The low values were made possible by a setup of the engines that could distinguish between test mode and normal operations. In test mode, the engines were electronically manipulated in order to only produce emissions below accepted thresholds. The scandal was disclosed by a Notice of Violation by the US Environmental Protection Agency and costed the German car manufacturer Volkswagen USD2.8bn in fines and about USD17bn in damages in the US alone.
For the purpose of this discussion paper, “Governance risks are the risks posed by the exposure of institutions to counterparties that may potentially be negatively affected by governance factors”.
Another transmission channel of ESG risks that is often stated in discussions on ESG factors is liability risk. Liability risk relates to the risks stemming from people or businesses seeking compensation for losses they may have incurred due to ESG factors, e.g. when institutions’ counterparties are held accountable for the negative impact through their activities on the environment, the society and their governance factors.
For the purpose of this discussion paper, “Liability transmission channels/liability risks are the risks posed by the exposure of institutions to counterparties that may potentially be held accountable for the negatively impact through their activities on the environment, the society and their governance factors.”
Multi-point impact of ESG risks on institutions:
Given that ESG risks can drive different prudential risk categories, they can impact the financial position of institutions in multiple ways. For instance, the physical deterioration of areas in which some economic activities (e.g. agriculture, construction) operate may lead to higher credit losses, if an institution is exposed to those activities via loans or bonds, or losses in market value, where the exposure is in the form of financial instruments. The necessary and politically agreed transition towards a more sustainable economy in general, and a carbon-neutral economy in particular, can also negatively affect existing business models. Credit and market losses translate into impacts on the capital adequacy and, thus, prudential soundness of an institution. Moreover, when credit agencies include ESG risks, the credit ratings of vulnerable corporates could be downgraded resulting in higher risk weights of affected exposures under the standardised approach. In addition, when ESG risks impair the valuation of collateral, this can increase the LGD. ESG risks can also cause an outflow of capital, for example, after a natural catastrophe. With regard to the costs of capital and funding, investors and depositors are likely to discriminate increasingly against institutions that disregard the negative effects of their activities on ESG factors.
The Second Annual Global Survey of Climate Risk Management at Financial Firms conducted by GARP found that the vast majority of institutions believes climate risk is either only partially included in pricing or even completely omitted. The publications of the ECB’s draft supervisory expectations relating to risk management and disclosure of climate related and environmental risks in May 2020, the NGFS’ ‘Status Report on Financial Institutions – Experiences from working with green, non-green and brown financial assets and a potential risk differential’ and the EBA Staff Paper on ESG Market Practices, further highlight the importance and urgency of enhancing the tools and methods for assessing and measuring ESG risks.
In this section, specific aspects relevant for the assessment by institutions and supervisors of ESG risks are presented. Section 3 focuses on two aspects of the risk management framework, namely the (i) identification and (ii) evaluation of ESG risks, as needed for the incorporation of these risks into the institutions’ decision-making (see Figure 7). Section 4 will elaborate more on the element of action. Specifically, the three elements can be depicted as follows:
a. Identification: This implies classifying assets according to their ESG characteristics in order to support the identification of ESG risks based on specific qualitative and quantitative indicators. This can be done, for example, through the categorisation of exposures (if applicable combined) across asset classes, sectors, counterparties, geographies or on the basis of their length of maturity or position in the life cycle of the asset. For instance, a geographic classification would help to identify the proportion of assets particularly vulnerable to the impact of physical risks in the form of higher sea-levels, droughts or other climate-related hazards in given regions, while a sector classification could be used to enhance the understanding of the share of exposures vulnerable to transition risks, for instance, in the form of regulatory changes and technological progress affecting those specific sectors. This classification process allows to identify the main potential drivers of ESG risks, consistent with the significance of the different ESG characteristics, which then justify a more granular analysis on the most relevant categories (e.g. a given geography, sector), if needed.
b. Evaluation: Once exposures have been classified, methodological tools would need to be applied and possibly combined to assess the potential impact of ESG risks on the institution’s ‘portfolios’. Given that methodologies to quantify ESG risks are evolving, a dynamic, flexible approach would be needed. For instance, some methodologies could fit well for the evaluation of ESG risks in exposures that are potentially vulnerable to misalignment with sustainable goals, like in the case of sovereign and public debt held by countries or regions that fail to comply with the Paris Agreement goals, while other methods may be needed to evaluate ESG risks stemming from the specific ESG-related features of a given counterparty (e.g. the labour code applied by a given company or the level of corruption in a given country).
Some ESG indicators, particularly those applicable to climate-related and environmental factors, are well-known and potentially fairly simple to calculate and apply. For instance, in the context of climate change, indicators for the production of greenhouse gas emissions are well-defined and can be measured, reported and verified with a high level of accuracy based on existing standards. Specifically, the ISO 14064-1:2018 standard applies a GHG Protocol methodology. In addition, the European Commission’s Recommendation 2013/179 on the use of common methods to measure and communicate the life cycle environmental performance of products and organisations provides further guidance on the use of environmental footprint methods.
At the European level, the European Commission’s ‘Guidelines on non-financial reporting: Supplement on reporting climate-related information’ from June 2019, which integrate the recommendations of the Financial Stability Board’s TCFD, provide a starting-point for some climate-related indicators. Moreover, the EU Taxonomy Regulation classifies environmentally sustainable economic activities based on uniform criteria.
The EU Taxonomy provides a starting point for the uniform identification and classification of economic activities that are conducive to a low-carbon, resilient and resource-efficient economy. The Taxonomy Regulation provides a harmonised set of criteria to identify environmentally sustainable economic activities, including enabling and transition activities (see Box 9). An explicit objective behind the establishment of the EU Taxonomy is to support the reorientation of capital flows towards sustainable investments.
The six environmental objectives covered by the Taxonomy Regulation are (1) climate change mitigation, (2) climate change adaptation, (3) sustainable use and protection of water and marine resources, (4) transition to a circular economy, (5) pollution prevention and control, and (6) protection and restoration of biodiversity and ecosystems.
On the one hand, the Taxonomy encompasses economic activities that make a substantial contribution to one of those environmental objectives based on their own performance, i.e. straightforward sustainable activities. On the other hand, the Taxonomy also recognises so-called “enabling activities”. These are the provision of products or services to other economic activities which then make a substantial contribution, e.g. the production of parts for a carbon-neutral power plant.
Compliance with the taxonomies and standards has supported the development of labels, which consist of certified accreditations that formally recognise compliance of financial products with given taxonomies and standards (for instance, for the issuance of a ‘green bond’, for the granting of an ‘energy efficiency mortgage’, etc.). Finally, in order to promote the integration of markets for green financial products globally, the EU has launched together with seven other countries the International Platform on Sustainable Finance (IPSF) with the aim of ensuring a global coordination of efforts on initiatives and approaches to sustainable finance, in particular regarding labels for sustainable financial assets, including green bonds.
On 17 July 2020, the European Commission adopted new rules setting out minimum technical requirements for the methodology of EU climate benchmarks. The new rules increase the level of transparency and comparability on the products developed by benchmark administrators, including the criteria for the benchmarks to be labelled as EU Climate Transition Benchmark or EU Paris-aligned Benchmark.
While providing the starting point for the identification of ESG risk, taxonomies and indicators by themselves are not sufficient for the estimation and evaluation of ESG risks (see Figure 7 above). Various methods exist for using and translating them into an assessment of ESG risks. Ultimately, all approaches have the same objective of assessing the alignment of institutions’ portfolios with global sustainability goals and offering insights into the risk caused by exposures to certain sectors (for example, to climate relevant sectors). However, there are different ways of achieving these objectives. Each approach is different in terms of what it measures and how the outcome can be used by institutions. The decision on which methodological approach to choose will also depend on the size, the complexity and the business model of the respective institution and consequently the approach taken by a small, non-complex institution will likely differ from the one taken by a large institution.
In what follows, methods for assessing ESG risks are divided into three different types of approaches:
a. Portfolio alignment method
b. Risk framework method (including climate-stress test)
c. Exposure method
For all methods described, the well-known issue of data gaps and often lack of reliable and comparable data applies and has to be kept in mind.
How aligned is an institution’s portfolio relative to global sustainability targets?
At the core of this methodological approach is the concept of alignment. The key principle behind this approach is for institutions, investors and supervisors to understand in how far portfolios are in line with globally agreed (climate) targets.
Looking specifically at climate, this approach outlines in how far an institution would need to change its portfolio and activities in order to align with the Paris Agreement 2 degree scenario. It looks directly at the ultimate goal of global efforts on climate change and explicitly defines the portfolio changes that would be required by institutions to contribute to this. Assessing the alignment of the portfolio with global targets in turn presents a way to measure ESG risk for the bank itself.
A well-known tool falling under this approach is the Paris Agreement Capital Transition Assessment (PACTA) tool developed by 2 Degrees Investing Initiative (2DII). The tool combines bank level portfolio information on client exposures, a database on the technology mix and production plans of individual companies and technology mix scenarios developed by the International Energy Agency (IEA) in order to assess an entity’s alignment with the Paris Agreement Targets (bringing the rise in temperature to well below 2 degrees).
The technology mix scenarios define pathways for CO2 emissions for certain technologies and industries, under various climate target scenarios, implying certain required technology mixes in the energy sector. The 2DII database holds information on the production plans of individual firms for the period 2019-2024 for climate relevant sectors. Production plans by individual firms together with the envisaged scenarios’ pathways for different sectors are combined to assess the alignment of each firm’s production plan to the scenarios developed by the IEA.
At the bank level, each client exposure is matched with the 2DII database on firms and their forward-looking production profiles is created. Individual institutions can then be assessed in how far the clients they finance are aligned to the International Energy Agency (IEA) targets.
The output of PACTA provides institutions with the following: i) how much of the portfolio consists of clients in transition relevant sectors, showing the share of the portfolio and the technology mix of the portfolio; ii) a comparison of step i) to peers and the market (i.e. exposure of the global universe of assets in the relevant asset class); iii) the alignment of the bank’s portfolio to the scenarios over a 5 year horizon, based on the production plans of clients in its exposure. (The tool can of course can also be used by other financial sector entities, such as insurers and asset management companies.)
Another framework that takes the alignment approach is UNEP FI’s Principles for Responsible Banking (PRB), launched in September 2019 by 130 banks from 49 countries. The aim of this framework is to ‘align banks’ business strategy with the goals as expressed in the SDG and the Paris Agreement. A key difference of this framework compared to the PACTA approach is that it takes into account all three components of ESG, not only the environmental component. Twenty-two ‘impact areas’ are defined in line with UNEP FI’s Positive Impact Initiative 2018 in the social, the environmental, the governance, as well as the economic pillar. Each impact area can be mapped to at least one of the 17 SDG’s.
The tool allows a mapping of participating banks’ exposures (by type, country and sector) to the different impact areas. The outcome is an overview for each bank in how far its exposures are positively or negatively affecting each impact area. Importantly, it builds a bank-specific list of most significant impact areas per bank. This is based on countries’ needs in each impact area for the bank’s countries of operation as well as impact areas related to sectors and countries where the bank is a market leader. Combined with an assessment of a bank’s (relative) performance on these most significant impact areas, the tool allows banks to set targets for each individual impact area.
The tool under the PRB is not based on quantitative scenarios like the PACTA Tool. Rather it provides a more qualitative mapping of the above-mentioned ‘impact areas’ to sectors and individual countries’ level of need. It involves subjective judgement both on the side of banks (when mapping the performance on most significant impact areas) and UNEP FI (when linking sectors with impact areas). Its all-encompassing scope of ESG and its differentiation across countries and banks’ own potential in the various impact areas, allows a holistic analysis on banks’ portfolios.
Signatory banks of the PRB are required to publish their targets, report publicly on their impacts and progress and engage with key stakeholder on their impacts, fostering transparency and accountability.
How will sustainability related issues affect the risk profile of a bank’s portfolio and its standard risk indicators?
Modelling the impact of ESG risks on banks’ risk profiles has seen most progress in the form of climate stress testing. This may inter alia be attributed to the fact that climate risk by its nature is forward-looking. Stress testing over a future horizon is therefore a useful tool to model climate risk impacts.
The most developed risk framework methods in the context of climate risk can be split into two approaches:
a. Climate stress tests – assessment featuring fully fledged scenarios that map out possible future development paths of transition variables (e.g. carbon prices), physical variables (temperature increases) and the related changes in macro variables (e.g. output in different sectors, GDP, unemployment) and financial variables (e.g. interest rates). These scenarios are then translated into changes in portfolios’ (risk) attributes.
b. Climate sensitivity analysis – a simpler exercise without scenarios, assessing changes in portfolios’ risk attributes by changing some of the inputs in financial models based on shading and classification of exposures into ‘green’ versus ‘non-green’ (which determines an exposure’s vulnerability to climate-related events and policies).
a. Climate stress testing
Several climate stress-testing methodologies have been proposed and applied. Stress testing can take place at portfolio, industry or counterparty level. Challenges include assumptions made about the different climate scenarios, uncertainties about climate developments themselves (tipping points), environmental policies adopted by national and international governments/bodies and actual implication for financial and economic factors and how these are modelled, choosing appropriate time horizons (which are longer for climate stress tests than for normal stress tests), taking into account transition or physical risk, accounting for changes in technology and consumer preferences, and, importantly, data availability.
Climate stress tests remain work in progress and should not be expected to provide the same level of precision as standard bank stress tests. To-date they remain of less comprehensive nature than the usual stress tests – they are an assessment of certain portfolios but do not make any conclusions about potential capital implications. Climate stress tests based on scenario analysis are a useful and important tool, however given their complexities and many uncertainties, they also need to be assessed and interpreted with caution.
Stress tests have also been developed for environmental stress such as pollution. Other stress tests are developed explicitly for the real estate sector, given its crucial contribution to climate change but also its exposure to physical risk.
b. Climate sensitivity analysis
Sensitivity analysis is a simpler form to integrate climate risk into financial risk modelling. It does not apply complex scenarios based on assumptions on time horizons and interlinkages between climate factors and the real economy, but instead integrates climate risk directly into financial risk indicators by stressing certain inputs, based on classifying exposures according to their positive or negative climate contributions.
Not requiring complex scenario based modelling can be seen as an advantage as it makes this approach simpler and more accessible. What it cannot provide however is a more dynamic and complex assessment of climate impacts. By definition, scenario analysis ignores many aspects, including the dynamics and interactions between different sectors, additional macroeconomic impacts resulting from climate change, and importantly it ignores negative feedback loops and the aspect of time (it is a one-point in time assessment).
Given the infancy of and uncertainties involved in climate risk modelling, this simpler approach can provide an insightful indication of the relative performance of ‘green’ versus ‘non-green’ exposures and banks’ exposures to climate relevant sectors.
How do individual exposures and clients perform in terms of ESG risk?
The third approach is a tool that banks can apply directly to the assessment of individual clients and individual exposures, even in isolation. The basic principle of this approach is to directly evaluate the performance of an exposure in terms of the E, the S and the G. This can then be used to complement the standard assessment of financial risk categories. Indicators used for this assessment are typically calibrated at company level, taking into account granular sectoral level characteristics to capture specific sensitivities of the ESG factors on different segments and sub-segments of economic activities.
This method can be described as the possibly most practical method and the most straight-forward to implement amongst the three approaches. It does not involve sophisticated scenario analysis based on many assumptions, but as a result relies on mainly backward-looking metrics. It can be applied to individual exposures and is a systematic approach classifying exposures by their specific ESG attributes. It provides banks and investors with a tool to better understand their individual counterparties and to better understand the ESG risk of their existing portfolio.
Several methodologies have been developed under this approach. They can be broadly classified into the following:
a. ESG ratings provided by specialised rating agencies (e.g. Sustainalytics, MSCI, ISS ESG, RobecoSam)
b. ESG evaluations provided by credit rating agencies (e.g. S&P’s ESG evaluation)
c. ESG evaluation models developed by banks in-house for their own assessment
d. ESG scoring models developed by asset managers and data providers, publicly available (e.g. State Street’s R-Factor, Refinitiv)
ESG ratings provided by specialised rating agencies are direct, stand-alone ratings on ESG factors, taking into account risk exposure to ESG factors as well as management’s capability to deal with risks or opportunities. These ratings can be either relative to industry peers (see MSCI ESG Ratings for instance) or absolute company ratings (see the rating by Sustainalytics). The methodologies generally build on quantitative analysis of key issues identified per industry (and hence company), as well as qualitative information collected by analysts from public information and client engagement.
All ESG evaluations aim to provide the needed additional input to existing financial risk assessment. Developing and interpreting the outcomes however also faces several challenges since the different approaches taken can have crucial implications for their comparability. For instance, ESG ratings often lead to very different outcomes for the same company. This is inter alia due to the fact that the importance of the same ESG factor for the same company is often assessed very differently across methodologies. Other factors contributing to the difficulties in comparing ESG ratings by different providers include the different weightings applied to the individual elements ‘E’, ‘S’ and ‘G’, whether, for instance, when looking at scope 1, 2 or 3 emissions for the E factor, or at the different treatment of lack of disclosure of information by companies.
A key step towards making ESG ratings and evaluations more comparable, transparent and as such more effective in their use, is a standardisation of the relevance and importance of different ESG factors for the various industries and companies. This direction has been taken by the Sustainability Accounting Standards Board (SASB), making a crucial contribution towards laying the basis for achieving consistency in ESG assessments (see Box 13).
The SASB has developed a publicly available Materiality Map, identifying financially material ESG issues for 11 sectors and 77 industries. Financially material factors are those that are likely to have a substantial impact on a company’s financial and operational performance. By nature, which ESG factors are material for a company depends on the company’s sector. The aim of the materiality map is to foster a common understanding of the relative importance of different ESG factors across various industries, thereby facilitating a consistent assessment of ESG risk.
The materiality map is complemented by Sustainable Accounting Standards. The latter identifies which factors should be reported and assessed to evaluate ESG performance. It provides as list of indicators relevant for a certain industry (such as for example the percentage of active workforce covered under collective bargaining agreements to assess labour force practices) and the rationale alongside this.
Whilst the SASB’s tools do not provide a direct ESG rating or scoring, they have the potential to play an important role in developing these. Providing a list of standardised ESG issues across industries and sectors permits consistent application by banks and investors for their ESG assessment of clients and portfolios and at the same time can be a signalling tool for companies to identify the areas they should focus on in order to improve their sustainability performance.
https://www.sasb.org/
The EBA Guidelines on Loan Origination and Monitoring specify that ESG factors should be taken into account in banks’ credit risk appetite, policies and procedures. In particular, the Guidelines outline specific processes and procedures banks should have in place when providing environmentally sustainable lending, including processes for assessing the credibility and business objectives of clients.
Portfolio monitoring in the context of ESG in turn is crucial as it allows the bank to spot difficulties and areas for concern and action early on and allocate capital accordingly. In particular, it enables an institution to gain experience and build historical data on ESG and the relative performance of portfolios, which is again critical for the future policies and strategies of an institution.
Exposure origination
Alignment Method – Understanding the state of alignment and potential for changes in the portfolio provides direction and allows for better-guided decisions on investment and sectoral focus at time of exposure origination. The method focuses more on assessing the exposure in the context of the entire portfolio composition.
Risk Framework Method – Stress testing or sensitivity analysis can provide insights into vulnerabilities of sectors for future investment or credit decisions. It can help inform appropriate pricing and term structure of a loan and make portfolio allocation decisions.
Exposure Method – Providing a detailed view of ESG issues by client, the exposure method seems appropriate for the screening conducted during the loan origination process. In particular because ESG evaluation can be available at company level, it allows for a detailed and customised assessment of clients.
Portfolio monitoring
Alignment Method – Understanding the positioning of a portfolio relative to targets allows identifying which parts of the portfolio are most likely to encounter difficulties in the future and require hence more attention and which portfolios may even need to be divested.
Alignment Method – Some methodologies can guide dialogue with client companies (through its insights on individual companies’ investment and production plans).
Risk Framework Method – Understanding the impacts of climate on the portfolio’s risk parameters is a crucial input to portfolio monitoring and capital allocation.
Exposure Method – It requires a substantial amount of evaluation in retrospect, but can be a useful tool for banks to understand in detail how their portfolio performs on ESG factors (‘shading of the portfolio’), can guide dialogue with clients and directs the latter on how and where improvements need to occur. This allows for a very customised tool.
Exposure Method
Pro’s
Con’s
Building on the definitions of ESG factors, ESG risks and their transmission channels, this chapter addresses how institutions can embed ESG risks in their governance and risk management. After describing the main practices currently followed by institutions (section 6.1), this chapter is structured around the three main elements where the incorporation of the ESG risks is seen as essential:
a. business strategies and business processes (section 6.2),
b. internal governance (section 6.3) and
c. risk management (section 6.4).
Smaller institutions are not immune to ESG risks and could be even more susceptible to them, for instance, if they are particularly concentrated in a vulnerable sector, geography or if they lack the resources and expertise needed to manage ESG risks. This is why it is important that all institutions effectively identify and monitor the ESG risks to which they might be exposed in the short, medium and long-run, and that they implement adequate measures to address them.
Incorporating ESG risks into institutions’ activities can be a complex task. Managing ESG risks requires a specific, long-term, forward-looking and comprehensive approach, which is at the same time flexible enough to account for ongoing developments in terms of the integration of ESG risks into the institutions’ business and risk management processes.
some credit institutions are accounting for ESG risks as more immediate financial risks in their business strategies and have decided to adapt risk management frameworks accordingly. Practical steps taken to achieve this objective included, among others:
a. DNB’s good practices publication in 2020 provides insights into how such a strategic approach to climate-related risks was adopted by one credit institution. In this case, an internal change program was introduced to understand the risks from climate change arising for the institution, the strategy was reviewed for necessary adaptions and the decisions subsequently implemented. In addition, and partly combining CSR and financial risk focuses, some credit institutions also reported in the EBA survey that they evaluate the impact of their lending, engage with clients about ESG risks, setting objectives for the share of investments that would need to meet positive ESG criteria or offering products such as green bonds or loans. Lastly, selected credit institutions have focused their business model on sustainability, declaring a significant importance of ESG considerations to their business strategy.
b. According to the above-mentioned PRA survey, around 60% of the respondents had adopted the approach of considering climate-related risks as more immediate financial risks, albeit in a mostly rather narrow and short-term fashion. Another 10% were found to have chosen a more comprehensive, “strategic” approach, including a more long-term, forward-looking perspective, developing asset classifications for climate-related risk analysis and increased board engagement as well as engagement with academia or hiring of specialists. The study conducted by the ACPR also confirms progress with regard to the integration of climate-related risk into institutions’ strategies and observes “advanced institutions” that have increased efforts in terms of quantifying climate-related risks, reviewing sectoral policies or aligning portfolios with climate change mitigation scenarios to reduce exposure to transition risks.
The EBA report on short-termism shows that the average time horizon for business planning and strategy setting considered by EU banks is currently three to five years, which is also in line with the time horizon required by some supervisory requirements. However, this time horizon is not likely to immediately reflect the often long-term impacts of climate change nor the transition to a more sustainable economy, e.g. in line with the objectives of international agreements, and may make them seem less relevant for institutions. Accordingly, the report concludes with a recommendation to integrate “requirements to implement long-term resilient business strategies” into the EU-level provisions, such as the CRD, for the banking sector.
The above-mentioned EBA’s survey conducted in 2019 showed that a growing number of credit institutions are working on determining the materiality of ESG risks. Although credit institutions assess climate-related risks (including both physical and transition) to be potential material risks for their activities, credit institutions’ current efforts to put in place specific risk management processes in relation to climate-related risks are limited. In particular, it appears that credit institutions have neither yet established key performance indicators that are necessary for a robust internal risk review process, nor more sophisticated modelling approaches.
The EBA findings are broadly in line with the evidence found by other surveys focusing mostly on climate-related risks only. Notwithstanding ongoing efforts and the progress made, most available studies and surveys call for a more assertive integration of climate risks as a financial risk, hence moving beyond a pure reputational risk focus.
The European banking sector has a long way to go in terms of addressing climate-related risks. While the surveyed banks have become much more transparent on their approaches to climate change in line with the TCFD recommendations, the sector performs the most poorly in terms of risk assessment and management of climate risks.
In May 2020, GARP Risk Institute published its second Global Annual Survey of Climate Risk Management at Financial Firms. In the survey, 85% of the 71 institutions show concerns over their resilience to climate change beyond 15 years. The main barriers to address climate risks mentioned by the respondents relate to the availability of reliable models and regulatory uncertainty, especially in the short term. In addition, most firms state that getting internal alignment on their climate risk strategy is a challenge in the short term.
Exclusion criteria on certain sectors and exposures are tools that institutions have begun to consider in their risk policies and risk management framework. Indeed, the findings of the EBA market practices survey shows that some credit institutions consider both positive and negative impacts of their investments and take those impacts into account for their financial decisions.
Asset managers use a number of approaches for the purposes of selecting exposures and implement sectoral exclusion policies:
a. Exclusion: the entity excludes from its investment range controversial assets (for example, negative environmental or social impact, corruption affairs) that do not match a minimum non-financial score established by an internal methodology designed by the entity;
b. Best-in-class: the entity is ranking companies by sector with an internal methodology (for example by GHG emissions) and allows for investment only, for example, in the three first companies in every sector. No economic sector is ignored using this approach;
c. Best-in-universe: the entity rank all the assets in its investment range using an internal methodology (again for example entities can be ranked on their GHG emissions) and is only choosing to invest in the assets ranked best. This can lead to ignore certain economic sectors;
d. Best-effort: the entity is choosing to invest in companies that have shown the best improvements regarding ESG factors (e.g. biggest GHG emissions reduction). Hence, these companies are not necessarily the best in terms of “absolute” ESG indicators;
e. Impact: the entity is selecting specific companies that have a positive impact regarding ESG criteria previously defined by the entity, e.g. a start-up developing an innovative ecological solution;
f. Normative: the entity is selecting investments regarding their compliance with international norms and standards.
From a prudential point of view, there are sound reasons for institutions to take ESG risks into account when assessing, designing or modifying their business strategy and processes. Notwithstanding the negative impacts from ESG risks that already occur in the short and medium-term, it is likely that the full impact of ESG risks will unfold over a longer time horizon. Therefore, if ESG risks are not duly taken into account in their business strategies, institutions might fail to modify their business models in a timely manner to avoid or mitigate the longer-term impacts of ESG risks.
Considering the relevance and potential impact of ESG risks, including them in the institution’s business strategy and business processes could be seen as inevitable for the institutions’ economic resilience over the long-term. By steering business into a direction that is consistent with the expected environmental and social transformation, institutions are more likely to avoid the negative impacts from ESG risks.
The UN 2030 Agenda for Sustainable Development and the Paris Agreement could be considered as the main global reference documents outlining commitments and vision for transforming the current global economy into a more sustainable one. In the EU context, the European Commission’s proposal for the so-called ‘European Climate Law’ sets the direction of travel for EU policy together with a more specific ‘Action Plan: Financing Sustainable Growth’. These have been supplemented by the Communication on the European Green Deal in December 2019, setting an EU strategy on sustainable finance and a roadmap for future work across the financial system, which is expected to be re-visited in the second half of 2020, following the public consultation of the European Commission on a renewed strategy on sustainable finance in April 2020. All these initiatives indicate significant changes of the business environment in the upcoming years.
At the same time, while the re-direction of socio-economic trends towards more sustainable paths takes place, the environmental conditions continue to deteriorate across the world, and reflection on these impacts of physical risks and environmental risks more generally in business strategies is equally important. The outbreak of the COVID-19 pandemic, with its unprecedented negative economic consequences, provides a good example that environmental hazards linked to ongoing biodiversity losses are an actual threat. From a financial perspective, more often and more severe natural disasters will be associated with bigger, potentially non-insured, losses that may rapidly threaten the solvency of households, businesses and governments, and therefore affect also the institutions.
In order to reflect the ESG risks in the institutions’ business strategies and business processes, the following areas in Figure 9 were identified as the most relevant:
a. monitoring the changing business environment and evaluating long-term resilience;
b. setting ESG risk-related strategic objectives and/or limits;
c. engaging with customers and other relevant stakeholders; and
d. considering the development of sustainable products.
Expected changes in the business environment in which institutions operate are typically monitored and reflected in the institutions’ business strategies. In this context, the effect of ESG factors on the business environment can be seen as relevant for the definition of institutions’ business strategies. This implies developing an understanding and monitoring of how ESG risks can affect macro-economic conditions as well as relevant sectoral business environments, for instance, through decreases in output, changes in customer preferences or shifts in technology, and of how this could in turn have negative financial implications for the institutions.
Consequently, the assessment of the business environment would be translated into considerations on how and to what extent ESG factors may change the risks to which the financial institution is exposed with a view to adapting its business strategy accordingly (for example by scenario analysis). When doing so, the specific characteristics and risks of the financial institution’s business model needs to be taken into account. Different risks may arise depending, amongst others, on the geographical location, counterparties and the economic sectors of its exposures. For example, a financial institution lending to SMEs located on a flood-prone area would face different impacts from ESG factors than an institution in a coal-intensive region heavily involved in the funding of coal-fired power plants.
When assessing the potential impact and materiality of ESG risks and in determining the resulting implications for the business strategy, it is essential to extend the planning horizons, which usually consist of 3-5 years, and equally consider risks to the business model in the longer run. This extension could be aligned with relevant public policies such as, for example, the emission reduction targets set for 2030. ESG risks and especially climate-related and environmental risks pose the challenge of manifesting not only in the short-run to medium-run, for example, due to an abruptly announced policy measure, but also over the following decades, because the physical impact of environmental change will affect economies and societies more permanently and severely, or because previously insufficient political action forces a sudden and comprehensive transition.
From a strategic point of view, institutions with a substantial proportion of their business in non-sustainable activities may face, in addition to potential financial impacts from exposures to sectors under pressure from stricter environmental or social regulation, reputational issues affecting their customers or investors base. The same could apply for institutions with a lack of commitment to sustainability objectives.
Corporate sustainability has been sometimes linked with the long-term competitiveness of corporations. Academic research shows various elements through which the long-term competitiveness might be affected, such as short-termism leading to underperformance in the long-term, both in terms of stock market as well as accounting and/or operational performance, ultimately resulting in lower returns on investment, or in difficulties to attract and retain high-quality staff, which may potentially translate into lower productivity and efficiency and, in the end, worse operational performance.
Designing (or re-designing) business strategies in order to take into account ESG risks can be based on the institutions’ existing internal processes used for translating analysis of trends and business environment into strategic objectives and/or limits.
Institutions that want to align their portfolios define ESG risk-related strategic objectives and/or limits as part of such strategies. These are in many cases disclosed and, within some international frameworks, the path to the fulfilment of the set targets is also monitored (e.g. Principles for Responsible Banking).
ESG risks are likely to affect different regions, economic (sub-)sectors, and assets differently. In light of this, the institutions’ overall objectives and targets may need to be translated into more specific targets (or limits), including exclusion policies for certain regions, sectors or activities (e.g. specific sectors or type of counterparties due to highly polluting production).
In a similar fashion, institutions could use the Sustainable Development Goals (SDG’s) to mitigate physical and transition risks, e.g., SDG 6-aligned investments in projects or firms providing sustainable water supplies, water storage, water-efficiency improvements or water treatment or SDG 11 to formulate a strategic objective on financing people’s access to safe, affordable, accessible and sustainable transport systems, notably by expanding public transport.
Strategic objectives and limits can also be formulated based on the EU Taxonomy (see Chapter 5). Institutions that wish to align more closely with the EU Taxonomy could, for example, set a target on a certain proportion of their overall credit or investment portfolios to be associated with activities that qualify as ecologically sustainable under the Taxonomy.
Another important aspect when considering the integration of ESG risks into the institution’s business processes relates to enhancing the institution’s direct and indirect engagement with borrowers, investee companies and other stakeholders. Direct engagement could comprise entering into a dialogue with the stakeholder’s management or exercising voting rights in its general meeting. Indirect engagement could happen via the publication of an institution’s ESG risk-related strategies and expectations towards stakeholders or through dialogue with industry associations.
The engagement policy should consider at least two perspectives that complement each other: First, the internal perspective, i.e. which capacities and expertise an institution needs to build up in order to understand the business models of its customers and the impact of ESG factors on them. Second, the external perspective, i.e. how an institution can interact with borrowers, investee companies and possibly other stakeholders to mitigate ESG risks for the institution that originate from such stakeholders.
While an institution may focus on sustainable activities to reduce ESG risks to its financial exposures, it can also try to address these risks by starting a dialogue with its counterparties regarding their adaptation to the transition to a more sustainable economy.
On a broader scale, institutions could consider engaging with sectoral organisations in order to promote a mutual understanding on how ESG risks may be addressed by companies in the context of a specific industry, and certainly in line with the relevant laws.
If deemed necessary, institutions could assist counterparties with the development of an action plan to gradually reduce their exposures to ESG risks and provide the necessary funding to implement the action plan.
With regard to retail clients, ESG risk-related engagement could, for example, address the energy efficiency of residential homes and the effect on the future value of the property. This could have a positive effect both on their ability to repay loans and the value of the collateral in case of default.
Where relevant, institutions could also define an engagement policy for their market exposures. This could include high level actions such as a public communication from the institution setting out which measures it expects from investee companies to mitigate ESG risks or exerting a more direct interaction with investee companies.
Where institutions hold equity investments that provide them with voting rights, they should take a strategic decision on how to use their voting rights in order to mitigate ESG risks stemming from investee companies. If the institution has adopted ESG risk-related objectives and/or limits, it seems reasonable to align the policy on the exercise of voting rights with them, considering potential limitations from the concept of “acting-in-concert”.
Another tool used by the institutions, to offer products and services meeting customers’ expectations on one side and to timely adapt the portfolio in order to reduce ESG risks on the other, is the strategic assessment of whether to develop sustainable products that are evaluated to be more resilient to ESG risks. These include products typically marked as ‘green’ or ‘social’.
Institutions that offer ‘green’ bonds use one of the existing market standards to structure their issuance. For example, the Green Bond Principles developed by the International Capital Market Association or the Climate Bonds Standard developed by the Climate Bonds Initiative were the standards mostly used at the time of the EBA market practices survey. In the EU, a proposal for the EU Green Bond Standard has been developed by the Technical Expert Group on sustainable finance of the European Commission (see Box 14). This standard is aligned with the EU Taxonomy.
The Green Bond Principles build around four key components: (1) use of proceeds, (2) process for project evaluation and selection, (3) management of proceeds, and (4) reporting. However, the GBP do not provide criteria for eligible projects. The Climate Bonds Standard provides sector-specific eligibility criteria for assets and projects.
The proposal for the EU Green Bond standard comprises four key elements:
a. alignment with the EU Taxonomy, as proceeds from EU Green Bonds should be used to finance or refinance activities that contribute substantially to at least one of the six environmental objectives, do not significantly harm any of the other objectives and comply with the minimum social safeguards. Where technical screening criteria have been developed, these should also be met, although the standard allows for deviations in specific cases;
b. publication of a green bond framework, which confirms the voluntary alignment of green bonds issued with the EU Green Bonds Standard, explains how the issuer’s strategy aligns with the environmental objectives, and provides details on all key aspects of the proposed use-of-proceeds, processes and reporting of the green bonds;
c. mandatory reporting on use of proceeds (allocation report) and on environmental impact (impact report);
d. mandatory verification of the green bond framework and final allocation report by an external reviewer.
Comparable to the Green Bond Principles, the Green Loan Principles establish four key components: (1) the use of loan amounts for verifiable environmental benefits that must be quantifiable by the borrower, (2) the process of evaluation and selection of projects, (3) the management of funds including tracking and (4) reporting. EeMAP is a market-led initiative that wants to create a standardised energy-efficient mortgage label in order to incentivise building owners to improve the energy efficiency of their buildings or acquire an already energy-efficient building through preferential financing conditions. The initiative follows two fundamental assumptions: (1) that improving the energy efficiency of a property has a positive impact on its value, and (2) that borrowers financing energy efficient buildings have a lower probability of default because of more disposable income in the household due to lower energy bills.
Based on the analysis presented, the EBA sees the need for enhancing the incorporation of ESG risks into the institutions’ business strategies and business processes. Adjusting the business strategy of an institution to incorporate ESG risks as drivers of prudential risks can be considered as a progressive risk management tool to mitigate the potential impact of ESG risks, in particular by:
Institutions’ internal governance arrangements, including the involvement of the management body in establishing a risk culture and setting the risk appetite and the implementation of a robust internal control framework are key aspects for a successful implementation of ESG considerations and managing ESG risks.
The management body’s involvement in overseeing the progress against the institution’s ESG risk-related objectives and/or limits, coupled with an understanding of the distinct elements of ESG risks and a sufficiently long-term view of the financial risks that can arise beyond standard business planning horizons, is necessary for the integration of these risks in the institutions’ business models and strategies. The supervisory role of the management body is crucial to ensure that sound and well-informed decisions are taken by the management body in its management function.
The management body needs to understand the potential impact of ESG factors and related ESG risks on the business model. Management and mitigation of the impact of ESG risks and anticipation of the possible changes in “market sentiment” of investors and the future choices of customers in a forward-looking perspective will increasingly impact the long term viability of the business model, and thus the role of the management body here is essential.
It is equally important that the members of the management body are collectively and key function holders who are individually suitable including that they have sufficient knowledge, skills and experience with regard to ESG factors.
Considering the relevance and potential impact of ESG risks, it is essential to include the tasks and responsibilities related to the incorporation of ESG factors into governance arrangements of the institutions. There are different ways how this could be implemented considering the size, complexity of the institutions’ activities and existing governance arrangements. For example, an existing risk committee operates with necessary tools accounting for the ESG risks in the process. Where applicable, it works together with one or more specialised ESG risk-related committees overseeing ESG risks with appropriate powers and membership. This could ensure a comprehensive approach to the incorporation of ESG factors into the business strategy, business processes and risk management, but the setup of specialised ESG risk-related committees in addition to an existing risk committee should be clearly justified. In case of smaller or less complex institutions, appropriate incorporation of the ESG factors into existing governance structures could be more suitable.
By the same token, a clear allocation and distribution of duties and tasks between specialised committees of the management body in its supervisory function is also key. Where so established, a specialised committee for overseeing ESG risks would ensure that ESG factors and risks are well considered within the internal governance framework of institutions. Such committees support the management body in its supervisory function and facilitate the development and implementation of a sound internal governance framework with regard to ESG risks. Members of the specialised committees on ESG risks should have appropriate knowledge, skills and expertise concerning ESG risks and assist the management body in its supervisory function with regard to the extent to which institutions’ activities are exposed to ESG risks. This would also allow that the organisational structure of the institutions considers the potential interaction between ESG risks and prudential risks, and that the former can drive prudential risks, in particular, in the long run. In general, neither ESG risks nor existing prudential risks should be managed or monitored on an isolated basis, but jointly.
The business lines and units taking risk have the primary responsibility for managing the risk generated by their activities throughout the lifetime of that activity. This general principle is equally applicable for the integration of ESG risks in the risk management and control framework. In this context, it is important to translate the ESG-related aspects of the business strategy into adequate internal processes and procedures in line with the institution’s risk appetite and risk management policies, credit risk and procedures, adopting a holistic approach. For example, the incorporation of ESG risks in the assessment of borrowers’ repayment capacity at the point of loan origination and the collection of relevant data for this purpose could provide necessary tools for the first line of defence to carry out its tasks effectively (see Figure 10). Similarly, institutions that originate or plan to originate environmentally sustainable credit facilities could introduce policies and procedures given various characteristics of the assets and the counterparties in question so that the staff members originating such credit facilities can account for ESG factors and risks in their activities.
Institutions set and operate risk management functions that are responsible for ensuring the proper risk controls. Incorporation of ESG risks, and in particular the specifics of ESG transmission channels (as described in chapter 4) into prudential risks categories, in this line of functions that are independent from the business lines and units would ensure that the long-term impact of ESG risks is accounted for in the decision-making process and overall minimise the institutions’ exposure to ESG risks.
The compliance function also complements the risk management framework and monitors the alignment of institutions’ activities with legal and regulatory requirements on all legal aspects, including ESG regulatory aspects and sustainability as well as institutions’ own internal policies. The risk management function and the compliance function play a key role in the approval of new products, e.g. environmentally sustainable credit facilities if relevant, or significant changes to existing products, processes and systems.
A robust and appropriate incentives-based mechanism is important to support achieving an appropriate risk culture and should account also for ESG risks. Remuneration policies and practices are applicable to all staff, but staff whose professional activities have a material impact on the institution’s risk profile (“identified staff”) is subject to additional requirements. Aligning the remuneration policy with the institution’s ESG objectives, e.g. long-term resilience of the business strategy under ESG considerations and risk appetite, is important to avoid conflicts of interest when business decisions are taken. Indeed, remuneration policies that are giving the right incentives to staff members to favour decisions in line with the institution’s ESG considerations, would facilitate the implementation of ESG risk-related objectives, as the staff members would benefit from meeting the long-term ESG risk-related objectives for the business activities of the institution, e.g. in the context of green credit-granting or reducing exposures highly affected by transition risk. The impact of the remuneration policies on the achievement of sound and effective long-term risk management objectives from the point of view of ESG considerations may be especially relevant when it comes to the variable remuneration of staff whose professional activities have a material impact on the risk of the institution.
Based on the analysis presented, the EBA sees a need for institutions to proportionately incorporate ESG risks in their internal governance arrangements. This should cover the management body and its ‘tone at the top’, allocation of tasks and responsibilities related to ESG risks as drivers of prudential risk categories in the decision-making process, adequate internal capabilities and arrangements for effective management of ESG risks, and remuneration policies that are aligned with long-term interests, business strategy, objectives and values of the institution. The EBA recommends institutions to achieve this by:
a. Considering ESG risks in the advisory role of risk committees or creating specialised committees such as sustainability finance committees or ethics committees, functions or working groups at different levels, proportionate to the size, complexity and business model of the institutions, and respecting appropriate independence and conflict mitigation considerations;
b. Ensuring that the relevant committees or working groups meet regularly to follow up on implications from an ESG risks perspective (e.g. strategy, reputation and ESG compliance of counterparties) and review if there is an adverse impact in relation to the relevant ESG limits of the institution;
c. Clearly justifying the need for specialised committees and, where applicable, establishing a clear working procedures for the interaction of such specialised committees, if they exist, with others such as risk committee and internal control functions;
d. Allocating the responsibility related to ESG risks to a member of the management body;
e. Involving the risk management function at an early stage when integrating ESG risks into the risk appetite of the institution;
f. Recruiting and training staff within the business units and internal control functions to enhance expertise to identify, assess and manage ESG risks;
g. Ensuring that risk management functions consider ESG risks when implementing risk policies and that their controlling of the risk management framework also extends to ESG risks;
h. Evaluating the extent to which the role of the risk management function needs to be modified for an adequate management of ESG risks;
i. Ensuring that the internal audit function includes ESG risks in its review of the effectiveness and adequacy of the internal governance arrangements, processes and mechanisms;
j. Encouraging staff behaviour that is consistent with the institutions’ ESG risks approach;
k. For institutions that have set ESG risks-related objectives and/or limits, considering implementing a remuneration policy that links the variable remuneration to the successful achievement of those objectives, while ensuring that green-washing and excessive risk-taking practices are avoided;
l. Establishing a framework to mitigate and manage conflict of interest which incentivise, short-term-oriented undue ESG-related risk-taking, including green-washing, mis-selling of products; and
m. Considering ESG indicators when taking into account the long-term interests of the institution in the design of their remuneration policies and its application.
As described in chapter 4, ESG risks can affect institutions in different ways and ultimately lead to financial impacts. An active ESG risk management is consequently fundamental to ensure that institutions identify such risks in a timely manner, hence being able to respond to them.
This section elaborates on specific aspects relevant for the institutions’ risk management of ESG risks, in particular related to:
a. risk appetite, risk policies and risk limits;
b. data and methodology;
c. risk monitoring and mitigation;
d. stress testing for climate risk.
Risk appetite means the aggregate level of types of risk an institution is willing to assume within its risk capacity, in line with its business model, to achieve its strategic objectives. The institution’s risk appetite specifies the scope and focus of the risk to which the institution is exposed to.
There are specific considerations relevant to incorporating ESG factors into the risk appetite framework. For example, the composition of the portfolio in line with the institution’s ESG risk-related strategic objectives and/or limits, and including its concentration, and diversification objectives in relation to business lines, geographies, economic sectors and products is important also from an ESG risks perspective.
Depending on the overall strategy and approach to transition risk, the relevant limits might need to be reviewed or extended to new types of limits relevant from the ESG perspective (e.g. sectors excluded from eligibility based on the institution’s business strategy). With regards to physical risks, institutions could set limits to consider the potential physical impact of geographical events such as floods and droughts on land, real estate, infrastructure projects and business activities in counterparty’s production cycle.
With regards to the risk strategy, risk appetite, and the overall risk policy it is important to ensure that these sufficiently reflect ESG factors as part of the overall framework. The risk appetite incorporating ESG risks would allow institutions to assess regularly their counterparties’ risk profile also from an ESG perspective and embed this approach in all the relevant processes of the risk management framework.
Risk management policies could foresee limits on financing projects or counterparties which significantly harm environmental or social objectives in line with the institution’s business strategy. Moreover, the institution could enter into a constructive dialogue with critical counterparties to eliminate or at least reduce the source of ESG risks from the counterparty to a level below the maximum limit set in the risk appetite framework. Further examples could consist of setting up an ESG scoring system and modifying credit conditions for borrowers included on an exclusion list, on the basis of their ESG score.
The risk appetite accounting for ESG risks would be implemented with the support of applicable ESG risks metrics and limits. These metrics and limits could cover key aspects of the risk appetite associated with the risk in question, as well as client segments, collateral types and risk mitigation instruments. The metrics would be mostly a combination of backward-looking and forward-looking indicators and tailored to the business model and complexity of the institution.
As the influence of ESG risks can be expected to increase, institutions should be in a position to assess whether ESG risks are becoming material financial risks drivers and, where appropriate, use all the available risk monitoring and mitigating tools for the relevant exposures. For example, for the purposes of managing concentration in credit risk, institutions set quantitative (and qualitative) internal credit risk limits for their aggregate credit risk, as well as portfolios with shared credit risk characteristics, sub-portfolios and individual counterparties. This is highly relevant from an ESG risks point of view. For example, concentration risk towards a specific counterparty carrying out unsustainable business activities or concentration of the banking activities in a specific geographical area that is of high risk due to environmental conditions or violation of human right is a significant challenge for institutions. Institutions can account for these ESG risks only when they strive to understand the ESG risks associated with their exposures through an effective dialogue and due diligence vis-à-vis their counterparties. The incorporation of these aspects in the institution’s risk appetite can be achieved by setting appropriate metrics, limits and corrective measures in case the limits will be exceeded.
For physical risks and transition risks, a high degree of granularity appears warranted, as it allows taking into account the differences in vulnerability within countries. Institutions should try, for instance, to identify the share of their counterparties’ assets located in geographical areas more vulnerable to acute or chronic physical risks and any measures taking by them to mitigate the vulnerability of those specific assets.
Data availability and accuracy is key for a robust risk management framework. Section 5.1 explained that the lack of data to identify and measure ESG risks is one of the main challenges faced by institutions. Further developments in the regulatory framework coupled with institutions’ efforts to collect ESG-related data from their counterparties will play a crucial role to address these challenges in the risk management framework.
In methodology building, it is essential to evaluate which of the existing methods can incorporate sufficiently the ESG factors and transmitted ESG risks into prudential risk categories, and what additional methods or approaches need to be incorporated to capture exposure-based and portfolio-based risk measurement and monitoring. For example, commonly used traditional credit risk indicators, such as probability of default (PD) and loss given default (LGD) are primarily based on historical data, which in most cases, do not reflect expected impact of environmental or social factors. The assessment of ESG risks in the initial methodology building might have to build on different metrics in order to take into account their realisation timeframe, whether in the short, medium or long-term, in a forward looking-manner.
As the evaluation of ESG risks involves a much longer time horizon than used in the existing risk management tools, forward-looking tools such as scenario analysis and stress testing are being explored by the institutions. It is essential for institutions to evaluate which methods and metrics are the most suitable for them, considering their strategy and overall approach to ESG risks.
Methodological challenges due to limited availability of data could hamper this quantitative analysis, especially for social and governance risks, for which prospective analysis such as scenario analysis are less developed than for climate and environment-related risks, and common sets of indicators are not yet finalised. Given the characteristics of these risks, institutions could rely first on qualitative information and a comprehensive and thorough due diligence process in order to establish a risk profile of the different counterparties. Such analysis could exhibit certain social and governance practices that could be incompatible with the institutions’ risk appetite. Nevertheless and ultimately, institutions could aim to establish quantitative metrics for assessing and monitoring social and governance risks. Improvements in data availability and quality in the context of methodology building would also enable institutions to be better informed when setting strategies and shaping the risk management framework.
Quantitative indicators can take the form of key performance indicators (KPIs), which capture both risk and opportunities, and allow a comparison between portfolios. Nevertheless, beyond a static monitoring of their exposures, institutions should also focus on evaluating potential current and future impact of ESG risks through scenario analysis. It might be less straightforward to translate social and governance risks into commonly agreed quantitative indicators.
ESG risks can drive market risks. For example, higher downside risks can be associated with financial instruments issued by companies that are environmentally unsustainable or socially irresponsible. Understanding and establishing a direct relationship between how ESG risks impact the issuers and how the value of the related financial instruments changes is challenging but it is important to assess and evaluate both the risk of losses and of increased volatility.
The level of the volatility is a further element to be considered. Investments in financial instruments issued by companies belonging to sectors perceived as not sustainable from an ESG perspective, or lacking an adaptation policy are more prone to be exposed to the effects of the news flow. Indeed, the price of such financial instruments will be more affected by policy and regulatory actions in the ESG space, as well as to the increasing percentage of investment funds allocating a minimum level of their Asset under Management to ESG compliant instruments.
The inclusion of ESG risks into the market risk strategy is not sufficient to ensure that the risk is properly addressed. An appropriate organisational framework is likewise needed. Such a framework shall clarify the responsibilities for deciding, implementing, monitoring and reporting the impact of ESG risks on the market portfolio of the institution.
ESG risks can drive operational risk, in particular via reputational risk and liability risk that can arise as a result of the institution’s activities. For instance, institutions’ financing activities that are publicly controversial (e.g. hydraulic fracturing or fossil fuel financing) might see their reputation impacted or might be subject to legal claims.
On the asset side, ESG factors can influence the value of financial assets, which in turn might affect the liquidity of that asset, thereby creating liquidity risk. This risk can also arise as the result of ESG events triggering a run on the bank: environmental crisis, like social unrests, can lead to higher withdrawals or stress in liquidity positions of the institution in a specific geographical area.
On the liability side of the balance sheet, ESG factors can affect availability and/or stability of funding (e.g. hampered or more expensive access to market funding, unstable deposits due to changing customer preferences), thereby creating funding risk. In this context it is important to acknowledge the potential effect of reputational issues on the funding of institutions.
As well as affecting the profit and loss account of institutions, both through micro-prudential factors and through macro-prudential factors, ESG risks can also affect the institutions’ balance sheet. ESG factors, both independently and through the aforementioned profit and loss account, affect institutions’ capital and liquidity adequacy, the risk weight of its assets, and its access to capital and liquidity.
When identifying and measuring or assessing risks, due to the unique characteristics of ESG risks, institutions would need to employ measurement methodologies that are able to capture the most relevant ESG factors and sufficiently deal with the fundamental uncertainty of such risks.
Institutions can manage ESG risks, at least to a certain level, by implementing an exclusion policy or by setting specific limits for tailor-made ESG risk indicators (see Annex 1). For instance, this can be done by integrating climate risk indicators in lending criteria (such as a maximum exposure level towards certain climate-sensitive sectors or individual counterparties).
Pricing is another element which should reflect also the risks driven from the ESG factors. Institutions should account for ESG risks in their pricing strategies. Indeed, as ESG factors are incorporated in the institutions’ risk appetite and business strategies, it will also be reflected in pricing together with other characteristics of the products. Similarly, it is important that an appropriate governance structure that accounts for ESG risks, complements the maintenance of an accurate pricing approach.
ESG risks require monitoring on a continuous basis, using tools, models and data. In order to do so, appropriate reporting frameworks, enhanced and supported by the underlying IT systems, seem essential. Accurate data and information related to ESG risks collected at the point of loan origination form the basis of the monitoring process for the purposes of risk management and throughout the lifecycle of the products.
(i) Main challenges of a climate risk stress test framework
The identification of exposures affected by climate-related risks represents the base of a climate risk stress test. Up until now, only limited empirical and sufficiently granular data exist to measure actual climate risk exposures; moreover, classifying green versus non-green exposures in a consistent way is currently one of the major challenges.
There are significant modelling challenges in calibrating scenarios for transition and physical risks given the interactions between policy, technology, and economic sector shocks. In addition, the assumption of longer time horizons challenges the way risks are usually assessed: transition risk scenarios often consider a time span from ten to thirty years while banks and supervisors typically use one to five-year periods to conduct business planning and stress testing exercises.
Transition risks vary across sectors depending on the adaptation pace and can change in the future: early adaptation (electric cars) versus late adaptation (coal power station). In light of this, historical information would not help modelling these risks especially in the long run. Therefore, to make an accurate assessment, banks require a methodology which also embeds these forward looking features and allows for capturing major differences in risks across various sectors or companies.
In light of these challenges, climate stress tests remain work in progress and should not be expected to provide the same type of outcome as standard supervisory stress tests. To-date, climate stress tests remain of less comprehensive nature than the usual stress tests and given their complexities and assumptions, they need to be assessed and interpreted with caution.
(ii) Main practices for climate risk stress test
Published methodologies are not always disclosed in detail and in some cases they are described at high level. In a first step, the channels through which the risk factors provided in the climate scenarios affect banks’ balance sheet are identified. Then, the shocks transmission mechanism to banks exposures is modelled. Climate risk stress methodologies are applied at different levels of aggregation depending on the data granularity available (loan, obligor or at sector level) and focus mainly on credit and market risk exposures.
Climate stress tests usually apply pre-defined climate scenarios (certain temperature pathways), which develop for instance emission reduction pathways associated with specific climate goals. The international scientific community has developed several databases identifying climate pathways (i.e. 2 degree consistent) and the implied trajectories for economic variables and sectors. This is done mostly through Integrated Assessment Models, which combine insights from various disciplines into one single framework, using socioeconomic, energy and climate factors. Instead of looking at scenarios satisfying certain temperature targets, climate stress can also be modelled through event-based shocks. These could be in the form of carbon taxes which increase the cost base of certain companies (a policy shock), technological breakthroughs which may imply a major shift away from certain industries (a technology shock) or changes in expectations and consumer behaviour (a preference shock).
Climate stress test methodologies are at an early stage. Supervisors have initially started to conduct exposure analyses to identify and quantify the potential implications of environmental risks on the banking and the insurance sectors. A few supervisors have conducted such analyses and translated their results into a heat map segmented across locations and sectors while others have classified credit and market risk exposures using CO2 emission data.
The EBA has launched in May 2020 a pilot sensitivity analysis with the aim of testing currently available methodologies and data availability regarding climate risk.
Based on the EBA’s analysis, it is important for institutions to incorporate ESG risks in their risk management framework, including origination and monitoring. Origination is the initial phase where institutions have the opportunity to collect the necessary information and data in relation to the ESG risks associated with the different elements of the transaction, e.g., the product itself, collateral or counterparty. The information and data collected at the initial evaluation phase would directly feed into the monitoring process. The same information and data would be used for risk management purposes throughout the lifecycle of the transactions and products, subject to necessary review and updates.
The reasoning and arguments presented in this report can be applicable to investment firms that are similar to credit institutions in terms of their business models and risk profile. The activities of these systemic and bank-like investment firms are exposed to credit risk, mainly in the form of counterparty credit risk, as well as to market risk for positions they take on own account, client related or not. In other words, those investment firms carry characteristics of credit institutions and may be subject to ESG risks in a similar manner.
There are also investment firms that are not systemic and bank-like. They are different from credit institutions in terms of their economic activities because they do not have large portfolios of retail and corporate loans. Therefore, the risks faced and posed by investment firms especially from an ESG point of view may have some differences compared to those faced and posed by credit institutions. For these investment firms, e.g. asset management companies, the materialisation of ESG risks would manifest in different risk metrics monitored under the IFD.
Given the importance of ESG risks, investment firms are expected to increasingly consider the ESG factors in their activities, investments in various assets on the markets, and potentially adjusting their investment behaviour reflecting their risk tolerance to the ESG risks (e.g. towards assets that are less prone to ESG risks or assets that create opportunities from a sustainability point of view). Such change in investment behaviour, impacted also by environmental regulation and consumer preferences, need to be supported also by adjustments in reporting and disclosure practices in line with the relevant legislative developments.
For the investment firms not dealing on own account, the impact of ESG risks would be limited, if it exists at all. In these cases, the ESG factors would not manifest directly on firms’ balance sheets. This would be the case especially for example, for investment firms that provide investment advice, manage portfolios on behalf of their clients, or execute orders on behalf of their clients. However, for investment firms that provide portfolio management there might be a second order effect, as their clients’ portfolios managed can be affected by ESG risks in a similar fashion to credit institutions as explained in this discussion paper, for example:
Assets under management: when significantly concentrated, e.g. in a specific geographical location or sector, specific assets under management are more prone to material ESG risks, and the value as well as the liquidity of these assets could fall. ESG risks materialise, affecting negatively the ability of financial assets to perform and, hence, causing the depreciation of assets. The effect on the investment firm could be the loss of dissatisfied clients (thereby, reducing the assets under management) or even claims for damages, e.g., where an investment firm has failed to correctly inform clients about potential ESG risks for their portfolios.
It is recognised that some aspects of adjustment of business strategies and processes, internal governance and risk management framework presented in this chapter, or some methodological approaches for assessing ESG risks may not be fully applicable for the economic activities of investment firms. However, the key arguments on the need to incorporate the ESG risks into the business strategies and processes are valid also for the activities of investment firms. Also the need to capture the ESG risks in the internal governance and risk management of investment firms, reflecting the specificities of their activities is equally valid.
Based on the mandates included in Article 98 (8) of the CRD and Article 35 of the IFD, the EBA shall assess the potential inclusion of ESG risks in the review and evaluation process performed by competent authorities.
The same arguments are valid to justify the need to reflect the ESG factors and ESG risks in the supervisory review in a proportionate manner. Negative impacts on institutions from ESG risks can already occur in the short and medium-term, and it is likely that the full impact of ESG risks will unfold over a much longer time horizon.
In terms of understanding the impact from ESG factors on the current business model, the following considerations appear most relevant for the quantitative analysis:
a. whether the reviewed credit institution derives a significant portion of its profitability from assets that are more exposed to ESG risks;
b. whether the credit institution observes differences in the profitability of conventional loans and loans that include ESG risk-related objectives;
c. whether the impairment of asset values is caused (partially) by ESG risks affecting such exposures and how this is assessed and quantified by the credit institution;
d. whether the balance sheet review reveals a problematic regional or sectoral concentration of assets, physical collateral or liabilities highly exposed to ESG risks, for example concentration of lending to or deposit-taking from households in a region where the economy heavily depends on carbon-intensive industries or that is prone to natural hazards.
With regard to the qualitative analysis the incorporation of ESG factors is equally relevant and could comprise at least the following areas of analysis:
a. the credit institution’s internal capacities including IT tools capable of identifying and evaluating ESG risks and sufficient staff with expertise in dealing with ESG risks;
b. the strength of the credit institution’s relationships with stakeholders in terms of pro-actively identifying their material ESG risks and implementing engagement strategies;
c. a potential competitive advantage of the credit institution due to the offering of sustainable banking products.
Where the credit institution has ESG risk-related strategic objectives and/or limits, the following aspects are of particular interest to supervisors:
a. the reasoning for such ESG risk-related objectives and/or limits (e.g. reputation, risk mitigation, growth opportunities);
b. which financial objectives the management body tries to achieve;
c. the level of ambition of such objectives compared to the overall strategy;
d. the interconnectedness with other, potentially conflicting objectives or limits;
e. major challenges that the credit institution is facing;
f. where the credit institution aims at aligning with sustainability standards, such as the SDGs, in how far the alignment responds to ESG risks or contributes to profitability;
g. where the credit institution offers sustainable banking products, whether they are also designed to mitigate ESG risks, e.g. by reducing exposure to activities particularly affected by the transition to a sustainable economy;
h. where the credit institution engages with its customers, how this is deemed to help mitigate ESG risks stemming from such exposures.
Supervisors may evaluate whether the strategy and financial plans adequately respond to ESG risks, i.e.,:
a. whether ESG risks impact the projected financial performance;
b. whether ESG risks-related objectives, sustainable banking products or engagement with customers on their preparedness and alignment with the transition are success drivers of the business strategy;
c. whether the credit institution accounts for the energy transition, climate change, digitalisation and other ESG issues in its macroeconomic assumptions;
d. whether the credit institution has the execution (know-how) capabilities to implement any ESG risks-related objectives and/or limits, judging from the track record of previous strategic adjustments and the availability of relevant expertise while acknowledging the relative novelty and potential complexity of ESG-related strategies.
The absence of ESG-related considerations in the business strategy should be critically challenged, taking into account that major parts of the economy will undergo unprecedented changes in the coming decades.
Under this minimum 3 year time horizon, supervisors would probably capture a broader scope of ESG risks compared to the 1 year in case of business model viability. For example:
given the longer term time horizon of the transition with climate mitigation targets being set for 2030 and 2050, this forward-looking assessment would similarly require a much longer time horizon, ideally aligned with the time horizon of such public policies, e.g. the emission reduction targets set for 2030.
Notwithstanding the importance of analysing the short and medium term impacts of ESG risks, the forward-looking assessment of longer term resilience could become a new area of business model analysis. It should take into account the projected longer-term changes to the business environment and shed light on the question how the credit institution’s business strategy responds to ESG issues which are supposed to fundamentally overhaul the economies and societies we are currently used to live in. In this context it is paramount that the business strategy is informed by scenario analysis on plausible future states of the economy.
The main objective of the supervisory assessment of the internal governance in credit institutions’ wide controls includes the evaluation of whether the credit institutions’ internal governance arrangements are adequate and commensurate to the credit institution’s risk profile, business model, nature, size and complexity. This assessment provides a supervisory view on whether the internal governance arrangements ensure a sound management of risks and include appropriate internal controls.
As stated in chapter 6, internal governance arrangements, including the involvement of the management body in providing the ‘tone at the top’, establishing a risk culture and setting the risk appetite and the implementation of a robust internal control framework with reporting lines clearly defined, are key aspects for a successful implementation of ESG considerations and managing ESG risks.
When evaluating the organisation and functioning of the management body, particular aspects that might be relevant for the supervisory assessment of the credit institutions’ internal controls of ESG risks include:
The main elements assessed by supervisors in the internals control framework are equally relevant with regard to ESG risk-related strategies, policies and procedures. Particular ESG aspects could be considered when evaluating the ‘lines of defence’ model, regarding the consistency in the implementation of ESG risk-related objectives and/or limits among the risk taking, risk management and internal audit function.
As for the risk management framework, it is important to ensure that ESG factors are sufficiently incorporated as part of the overall framework. When supervisors evaluate the appropriateness of the risk management framework, particular ESG aspects might be relevant when assessing:
a. whether the risk strategy, risk appetite and risk management framework are appropriate. In particular, considering whether the identified ESG risks are sufficiently reflected in the risk strategy, risk appetite and risk measurement and monitoring methods, including a set of ESG factors monitored for existing exposures to evaluate their relevance from a prudential risks perspective and modelling (e.g. new factors for credit risk models) as well as an identification process for newly relevant ESG factors;
b. whether the ICAAP and ILAAP frameworks incorporate ESG risks and transmission channels into prudential risks;
c. whether the credit institution has sufficient stress testing capabilities to evaluate ESG risks;
d. whether the risk management function has sufficient expertise in evaluating ESG risks (e.g. ability to evaluate longer term risks or specific aspects of transition risks, physical risks, social and governance risks).
Conclusions and policy recommendations
This section explores which ESG factors and ESG risks are relevant for understanding and evaluating the risks to capital.
In assessing such risks, it is important to be mindful of the evolving understanding of ESG risks: while it is fundamental to gauge the level of risk to which credit institutions are exposed to, it is equally important how credit institutions intend to establish and improve their measurement and management of ESG risks and catch up with the latest methodological and organisational developments.
In assessing how ESG risks drive the credit risk profile of credit institutions, it is important to design a minimum set of controls in order to form a view on how the credit institution is managing ESG risks.
A key characteristic of ESG risks, and especially climate-related and environmental risks, is their manifestation not only in the short- to medium-run, for example, due to an abruptly announced policy measure, but also over the following decades, because the physical impact of environmental change and/or because previously insufficient political action forces a sudden and comprehensive transition.
In order to properly capture the level of ESG risks to which credit institutions are exposed, it is important to understand the fundamental differences between the standard credit risk assessment, and their adaptations in order to take into account ESG risks. While credit risk is generally assessed in the short to medium term, the introduction of ESG controls in the credit risk assessment carries the need to enhance the extension of the horizon of the analysis through the use of forward looking metrics (e.g. scenario analysis). This is in particular the case for long-term loans such as in real estate financing, revolving credit facilities or in long-standing business relations with clients where expiring loans are usually renewed or replaced.
In this respect, a starting point is always the assessment of the underlying assumptions and strategies of the credit institutions, including:
ESG risks should be considered in the assessment of the risk profile of the counterparty. At portfolio level, ESG risks can be assessed by means of concentration analysis (considering both counterparties and/or collateral) and with a review of the specialised lending portfolio. In the subsequent paragraphs a list of controls is provided as an example.
Sectoral concentration can provide an overview of the exposure to transition risk when matched with transition risk metrics. This methodology has been largely explored in assessing how sectors are impacted by ESG risks.
Specialised lending and project financing deserves a specific mention. It is likely that credit institutions will consider using such products to finance projects with low ESG risks of counterparties more exposed to ESG risks. Indeed, such products are also more easily linkable to ESG issues compared to the overall exposures to a single counterparty. While transition projects might carry a lower risk as they mitigate the exposure to ESG factors, supervisors need to ensure that the use of project financing does not circumvent the assessment of how much counterparties are exposed to ESG factors, for instance by granting particularly favourable terms on a project facility with low ESG risks, while the counterparty as such is heavily exposed to ESG factors.
The incorporation of ESG risks into the review of the credit quality of the portfolio carries a number of questions. The assessment is also dependent on the availability of reliable data and information and on the development of appropriate supervisory methodologies.
A starting point for the valuation of exposures is the concept of stranded assets. Assets impacted by the transition (e.g. high polluting assets) or by physical events (e.g. floods) are potentially affected by lower valuations.
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Investors and market participants show a growing awareness of the importance of ESG risks. Although the level of ESG issuances is still low compared to the size of the financial markets, demand for ESG investments is increasing. At the same time, more and more investors are implementing negative screening policies and proxy voting policies which are solidly grounded in ESG considerations. For such reasons, it is important that supervisors assess how credit institutions proactively monitor the impact of ESG risks on their market risk positions.
This can be achieved by reviewing whether the proper set of controls to detect the emergence of ESG risks is in place, for instance, with the methodologies reported in chapter 5 and whether credit institutions have put in place a proper ESG strategy for market risk.
By reviewing the market risk strategy, supervisors will find important information on how the credit institution responds to ESG risks in the financial market. The presence of specific investment criteria, including ESG checklists and the requirement on a proper due diligence on market investments are all positive signs of how much the credit institution has engaged with the topic.
As per the lack of data, supervisors might check that credit institutions have clear policies for deciding on investments where they lack reliable ESG data. In this respect, the presence of negative screening policies or exclusion criteria, for example, can provide comfort that the credit institution is carefully reflecting on its market exposures even in cases where the appropriate data are not available.
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While the link between the ESG risks and liquidity and funding is seen by the credit institutions as more indirect, it is deemed important to not overlook these links when evaluating the risks to liquidity and funding. For example, the NGFS Guide for supervisors refers to liquidity risk in the context of a lack of reliable and comparable information on climate-sensitive exposures, which could create uncertainty and cause procyclical market dynamics, including fire sales of carbon-intensive assets, and potentially liquidity problems.
As indicated in chapters 4 and 5, ESG factors could also result in funding issues for a credit institution (e.g. deriving from reputational risk associated with a firm which does not integrate climate risks or other ESG risks in its strategy) or make some assets less liquid (e.g. behavioural changes of investors due to shifting preferences).
ESG factors and ESG risks are also relevant when assessing the inherent funding risk. On the liability side, ESG factors can affect availability and/or stability of funding (e.g. hampered access to market funding, unstable deposits).
Supervisors assess the credit institution’s funding risk and whether the medium- and long-term obligations are adequately met with a range of stable funding instruments under both normal and stressed conditions. Under this assessment the ESG factors and ESG risks seem to be the most relevant to consider when conducting:
This Annex proposes a non-exhaustive list of ESG factors and corresponding indicators that can help institutions and supervisors to identify ESG characteristics. They can be applied in a proportionate manner to financial transactions conducted with entities, sovereigns or individuals and allow for the aggregation and comparability of ESG characteristics across such financial transactions. Factors and indicators should be considered in the context of the performance and characteristics of the counterparty under consideration, not the institution’s own performance.
The list presented is solely an illustration of some of the key aspects and elements to be considered for the management of ESG risks. It should not be understood as an exhaustive or final inventory of all relevant factors and indicators, not least because these will evolve and will need to be updated over time. The applicability of the various ESG indicators will depend on the specific nature and underlying characteristics of the given exposures, taking into account the materiality of the ESG risks. Further, the evaluation and interpretation of the metric values and outcomes will crucially depend on an exposure’s nature and specific circumstances and may need to be considered on a case-by-case basis.
The indicators are further refined into concrete metrics. The latter are of both quantitative and qualitative nature. Some define clear calculations and formulas, depending on the relevance and context, some are in the form of an absolute measure (totals), others in the form of a relative measure (ratio). Some qualitative information on ESG characteristics can also be included in the form of certifications on the observance of ESG-standards/norms by third-party verifiers (e.g., in the form of labels), which may not necessarily be included in this list.
(a) ‘GHG emissions’ as defined in the GHG Protocol methodology (https://ghgprotocol.org/calculation-tools) or the ISO 14064-1:2018 standard and, where appropriate, with the European Commission’s Recommendation 2013/179 on the use of common methods to measure and communicate the life cycle environmental performance of products and organisations;
(b) ‘scope 1, 2 and 3 GHG emissions’ mean the greenhouse gas emissions referred to in point (1)(e)(i-iii) of Annex III of Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014;
(c) ‘Tonnes of CO2’ mean tonnes of carbon dioxide equivalent as defined in Article 3(j) of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union and amending Council Directive 96/61/EC;
(d) ‘Carbon footprint’ an absolute or relative measure of GHG emissions as defined in points (a) and (c);
(e) ‘fossil fuel sectors’ relates to the production, processing, distribution, storage or combustion of fossil fuels, with the exception of investment related to clean vehicles as defined in Article 4 of Directive 2009/33/EC of the European Parliament and of the Council on the promotion of clean and energy-efficient road transport vehicles;
(f) ‘national emissions reduction commitments’, for EU countries, obligations to reduce emissions of a given substance, specifying the minimum emission reductions that have to be achieved in the target calendar year, as a percentage of the total of emissions released during the base year (2005), as per Directive (EU) 2016/2284 of the European Parliament and of the Council of 14 December 2016 on the reduction of national emissions of certain atmospheric pollutants, amending Directive 2003/35/EC and repealing Directive 2001/81/EC (OJ L 344, 17.12.2016, pp. 1-31). For other countries, refer when available to intended nationally determined contributions to reduction in GHG emissions under the United National Framework Convention on Climate Change (UNFCCC);
(g) ‘energy consumption intensity’ measures the energy consumption per unit of activity, output, in the meaning of Directive ((EU) 2018/2002) amending the Energy Efficiency Directive (2012/27/EU);
(h) ‘renewable energy sources’ mean energy from renewable sources referred to in Article 2(1) of Directive (EU) 2018/2001 of the European Parliament and of the Council of 11 December 2018 on the promotion and use of energy from renewable sources (recast);
(i) ‘non-renewable energy sources’ mean energy from sources other than those referred to in point (h);
(j) ‘water consumption intensity’, in the meaning of Directive 2000/60/EC of 23 October 2000 establishing a framework for Community action in the field of water policy with a view to protecting the sustainable use and environmental status of all waters;
(k) ‘hazardous waste’ means hazardous waste as defined in Article 3(2) of Directive 2008/98/EC of the European Parliament and of the Council of 19 November 2008 on waste and repealing certain Directives and radioactive waste;
(l) ‘non-recycled waste’ means any waste not recycled within the meaning of ‘recycling’ in Article 3(17) of Directive 2008/98/EC;
(m) ‘water pollutants’ mean Direct Nitrates (scope 1), Direct Phosphate emissions (scope 1), Direct Pesticides emissions (scope 1), Direct emissions of priority substances (scope 1) as defined in the Directive 2000/60/EC of the European Parliament and of the Council of 23 October 2000 establishing a framework for Community action in the field of water policy, Council Directive of 12 December 1991 concerning the protection of waters against pollution caused by nitrates from agricultural sources (91/676/EEC), Council Directive 91/271/EEC of 21 May 1991 concerning urban waste-water treatment and Directive 2010/75/EU of the European Parliament and of the Council of 24 November 2010 on industrial emissions (integrated pollution prevention and control);
(n) ‘air pollutants’ mean Direct Sulphur dioxides (SOx/SO2) emissions (Scope 1), Direct Nitrogen oxides (NOx/NO2) emissions (Scope 1), Direct Ammonia (NH3) emissions (Scope 1), Direct Particulate matter (PM2.5) emissions (Scope 1), Direct Non-methane volatile organic compounds (NMVOC) emissions (Scope 1), Direct total heavy metals (HM) emissions (Scope 1) as defined in Directive (EU) 2016/2284 of the European Parliament and of the Council of 14 December 2016 on the reduction of national emissions of certain atmospheric pollutants, amending Directive 2003/35/EC and repealing Directive 2001/81/EC;
(o) ‘biodiversity and ecosystem change’ means the global assessment report on biodiversity and ecosystem services of the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES), released in May 2019;
(p) ‘protected area’ means an area designated under the European Environment Agency’s Common Database on Designated Areas (CDDA);
(q) ‘area of high biodiversity value outside protected areas’ means an area not subject to legal protection, but recognised for important biodiversity features by a number of governmental and non-governmental organisations, including habitats that are a priority for conservation, which are often defined in National Biodiversity Strategies and Action Plans prepared under the United Nations (UN) Convention, ‘Convention on Biological Diversity’, 1992;
(r) ‘gender pay gap’ means the difference between average gross hourly earnings of male and female income-earners for equal work or work of equal value, as a percentage of male gross earnings;
(s) ‘human rights policy’ means a policy commitment approved at highest decision-making level on human rights;
(t) ‘workplace safe and healthy’ as specified in the Directive 89/391/EEC, the so-called OSH “Framework Directive”, which lays down the main principles to encourage improvements in the safety and health of workers at work, and the requirements developed thereafter by the Commission and the European Agency for Safety and Health at Work (EU-OSHA).
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