Climate change and the response to it by the public sector and society in general have led to an increasing relevance of environmental, social and governance (ESG) factors for financial markets. It is, therefore, essential that financial institutions are able to measure and monitor the ESG risks in order to deal with risks stemming from climate change (learn more about climate change related risks in our previous Blogpost.
To support this, on 6 December
2019, the European Banking Authority (EBA)
published its Action Plan on Sustainable Finance outlining its approach and
timeline for delivering mandates related to ESG factors. The Action Plan explains
the legal bases of the EBA mandates and EBA´s sequenced approach to fulfil
these mandates.
Why is EBA in charge ? EBA mandates on sustainable finance
The EBA´s remit and mandates on
ESG factors and ESG risks are set out in the following legislative acts:
- the
amended EBA Regulation;
- the
revised Capital Requirements Regulation (CRR
II) and Capital Requirements Directive (CRD V);
- the
new Investment Firms Regulation (IFR)
and Investment Firms Directive (IFD)
and
- the
EU the Commission´s Action Plan: Financing Sustainable Growth and related
legislative packages.
These legislatives acts reflect
a sequenced approach, starting with the mandates providing for the EBA to
oblige institutions to incorporate ESG factors into their risk management as
well as delivering key metrics in order to ensure market discipline. The national
supervisory authorities are invited to gain an overview of existing ESG-related
market risks. In a second step, the EBA will develop a dedicated climate change
stress test that institutions should use to test the impact of climate change related
risks on their risk-bearing capacity and to take appropriate precautions. The
third step of the work will look into the evidence around the prudential
treatment of “green” exposures.
The rationale for this
sequencing is the need firstly to understand institutions´ current business mix
from a sustainability perspective in order to measure and manage it in relation
to their chosen strategy, which can then be used for scenario analysis and
alter for the assessment of an appropriate prudential treatment.
Strategy and risk management
With regard
to ESG strategy and risk management, the EBA already included references to
green lending and ESG factors in its Consultation
paper on draft guidelines on loan origination and monitoring which will
apply to internal governance and procedures in relation to credit granting
processes and risk management. Based on the guidelines the institutions will be
required to include the ESG factors in their risk management policies,
including credit risk policies and procedures. The guidelines also set out the
expectation that institutions that provide green lending should develop
specific green lending policies and procedures covering granting and monitoring
of such credit facilities.
In addition,
based on the mandate included in the CRD V, the EBA will asses the development
of a uniform definition of ESG risks and the development of criteria and
methods for understanding the impact of ESG risks on institutions to evaluate
and manage the ESG risks.
It is
envisaged that the EBA will first publish a discussion paper in Q2-Q3/2020
seeking stakeholder feedback before completing a final report. As provided for
in the CRD V, based on the outcome of this report, the EBA may issue guidelines
regarding the uniform inclusion of ESG risks in the supervisory review and
evaluation process performed by competent authorities, and potentially also amend
or extend other policies products including provisions for internal governance,
loan origination and outsourcing agreements.
Until EBA
has delivered its mandates on strategy and risk management, it encourages
institutions to act proactively in incorporating ESG considerations into their
business strategy and risk management as well as integrate ESG risks into their
business plans, risk management, internal control framework and decision-making
process.
Key metrics and disclosures
Institutions
disclosures constitute an important tool to promote market discipline. The
provision of meaningful information on common key metrics also distributes to
making market participants aware of market risks. The disclosure of common and
consistent information also facilitates comparability of risks and risks
management between institutions, and helps market participants to make informed
decisions.
To support
this, CRR II requires large institutions with publicly listed issuances to disclose
information on ESG risks and climate change related risks. In this context, CRR
II includes a mandate to the EBA according to which it shall develop a
technical standard implementing the disclosure requirements. Following this
mandate, EBA will specify ESG risks´ disclosures as part of the comprehensive
technical standard on Basel´s framework Pillar 3.
Similar
mandates are contained in the IFR and IFD package. The IFD mandate for example
requires EBA to report on the introduction of technical criteria related to
exposures to activities associated substantially with ESG objectives for the
supervisory review and evaluation process of risks, with a view to assessing
the possible sources and effects of such risks on investment firms.
Until EBA
has delivered its mandates, it encourages institutions to continue their work on
existing disclosure requirements such as provided for in the Non-Financial
Reporting Directive (NFRD) as well
as participation in other initiatives. EBA also encourages institutions to
prioritise the identification of some simple metrics (such as green asset ratio)
that provide transparency on how climate change-related risks are embedded into
their business strategies, decision-making process, and risk management.
Stress testing and scenario analysis
The EBA
Regulation includes a specific reference to the potential environmental-related
systemic risk to be reflected in the stress-testing regime. Therefore, the EBA
should develop common methodologies assessing the effect of economic scenarios
on an institutions´ financial position, taking into account, inter alia, risks
stemming from adverse environmental developments and the impact of transition
risk stemming from environmental political changes.
Also the CRD
V mandate requires EBA to develop appropriate qualitative and quantitative
criteria, such as stress testing processes and scenario analysis, to asses the
impact of ESG risks under scenarios with different severities. Hence, EBA will
develop a dedicated climate stress test with the main objective of identifying
banks´ vulnerabilities to climate-related risks and quantifying the relevance
of the exposures that could potentially hit by climate change related risks.
Until
delivering its mandates, EBA encourages institutions to adopt climate change
related scenarios and use scenario analysis as an explorative tool to
understand the relevance of the exposures affected by and the potential
magnitude of climate change related risks.
Prudential treatment
The mandate
in the CRR II asks EBA to assess if a dedicated prudential treatment of
exposures to assets or activities associated with environmental or social
objectives would be justified. The findings should be summarised in a report
based on the input of a first to be published discussion paper.
Upshot
Between 2019
and 2025, the EBA will deliver a significant amount of work on ESG and climate
change related risks. The obligations for institutions with regard to a
sustainable financial economy and a more conscious handling of climate change related
risks are becoming increasingly concrete. Institutions should take the EBA’s
encouragement seriously and consider applying the measures recommended by the
EBA prior to the publication of any guidelines, reports or technical standards.