The European Commission Climate Action Plan’s objectives are to reorient capital flows towards sustainable investment, manage financial risks stemming from climate change, resource depletion and foster transparency and long termism in financial and economic activity. The EU Green Deal seeks to support the reorientation of capital through the publication of the EU Taxonomy, the Sustainable Financial Disclosure Regulation and other steps.
On the other side of the coin institutions are exposed to climate risk in their existing portfolios, investments and new lending activities. These risks need to be assessed, managed and mitigated so that institutions can reorient their business strategy and governance systems to address climate-related and environmental risks.
The ECB recently outlined its supervisory expectations of institutions with respect to climate-related and environmental risks (the “Guide”)1, pursuant to its existing mandate under the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR). The CRD and CRR impose certain governance obligations on institutions, including requirements to implement internal governance arrangements, processes and mechanisms to ensure effective and prudent management of an institution. The Guide describes how institutions should consider climate-related risks when formulating business strategy and governance and risk management frameworks.
Climate-related and environmental risks are driven by:
- physical risk, i.e. the financial impact of changing climate such damage to property or disruption to supply chains from extreme weather events;
- transition risk, i.e. the financial loss that can result from adjustment to lower-carbon and environmentally sustainable economy.
Reflecting the fact that for a second year in a row the ECB identified climate-related risk as the key risk driver in the SSM Risk Map for the Euro area banking system, the ECB addressed its supervisory expectations for climate-related and environmental risks (“climate risks”) in the short to medium (3-5 years) and long-term (5 years +). The intention being to avoid the typical mismatch of short-termism in financial markets against the longer time horizon in which climate risks materialise in order to build resilience. In the Guide the ECB looks at the governance and risk management by institutions of climate risks across a number of areas of an institutions’ business:
- Business environment
- Business strategy
- Risk Appetite
- Organisational structure
- Risk management
- Credit risk management
- Operational risk management
- Market risk management
- Scenario analysis and stress testing
- Liquidity risk management
The Guide addresses lending activities specifically in light of climate risks, identifying issues such as the following which will need to be addressed:
- Proper climate risk due diligence to be carried out at the start of a client relationship and on an ongoing basis. Institutions must be aware of their clients’ impact on and vulnerability to climate risks and their approach to managing impact and risk.
- Climate risk impact should be assessed on institutions capital adequacy.
- Consideration of climate risks at all relevant stages of the credit-granting process and monitoring of risks in portfolios, and in credit risk policies and procedures.
- Formation of an explicit opinion on how climate risks affect a borrower’s default risk by identifying the climate risk factors material to default risk of the loan exposure and the quality of the borrowers own management of climate risks.
- Adjusting risk classification procedures to identify borrowers exposed directly or indirectly to increased climate risks.
- Consideration of how climate risks might impact collateral valuations,
- Monitoring and managing sectoral and geographic concentration factors, such as the distribution of energy efficiency labels across residential and commercial real estate portfolios.
- Loan pricing frameworks should support the chosen climate risk strategy and the difference costs driven by climate risks.
- Consideration of how climate risk events could have adverse impacts on business continuity or increase reputational or liability risks.
- Monitoring on an ongoing basis the effect of climate risk factors on their current market risk positions and future investments and develop stress tests that incorporate climate risks.
- Incorporation of material climate risks into institution’s stress testing and baseline and adverse scenarios including: o the impact of physical and transition risk; o how climate risk might evolve; o how climate risks may materialise in the short, medium and long-term.
The Guide and supervisory expectations outlined in the Guide whilst stated not to be binding on institutions are expressed as a basis for supervisory dialogue, significant institutions are expected to use the Guide taking into account the materiality of their exposure to such risks. Less significant institutions are recommended to take the Guide into account in a manner that is proportionate to the nature, scale and complexity of their activities. The Guide applies as of its date of publication, November 2020.
The Guide emphasises the taking of a holistic approach by institutions across their entire governance structure, business strategy, risk management framework, risk appetite, internal audit, accountability and robust reporting to management/the board of directors. It demonstrates the scale of adjustment required by institutions, some of which is already underway but clearly will require significant internal change in order to identify, manage and mitigate the climate risks their activities finance and to enable institutions to deliver the relevant sustainability disclosures and ultimately demonstrate their green and sustainable credentials. Most importantly it demonstrates the changes required across the full breadth of institutions and that it is not simply a matter of financing renewable energy projects, but will require a rethink of their entire loan portfolios and credit granting process.
The jigsaw pieces of the EU Climate Action Plan are rapidly falling into place as climate risk informs every action taken by EU institutions and member states as the European Climate Law proposed by the Commission will set the EU Green Deal goal of net zero greenhouse gas emissions by 2050 as a legally binding target.
For more information on the EU Green Deal, see our series of briefing notes on its components, available on the Philip Lee website.
As noted above, the Guide is effective as of its publication date. The next dates that banks need to focus on are:
- Self-assessment on ECB expectations early 2021 followed by development of action plans;
- Full ECB review of bank practices in 2022;
- 2022 supervisory stress tests will focus on climate risks.