ECB takes a stand on climate-related and environmental risks

On 20 May 2020 ECB released its guidelines on climate-related and environmental risks for public consultation[1]. The public consultation period runs until 25 September 2020 and is a first step to a structured dialogue with significant institutions (SIs).

The intention of these guidelines is to set out supervisory expectations on the integration of these risks into existing practices and initiate a dialogue between supervisors and industry. As such, it complements the Paris Agreement [2] and the European Commission’s action plans on the transition to a low-carbon economy, further recognising the key role of the financial services industry in achieving ambitious targets until 2050[3].

Introduction

While the guidelines are of a non-binding basis, the ECB has explicitly formulated a set of 13 supervisory expectations. The guidelines are applicable from the point of publication, with institutions required to inform the ECB of any divergence from the guidelines by the end of 2020.

The guidelines have been developed jointly by the ECB and national competent authorities (NCAs). Institutions under its direct supervision are expected to use the guidelines in enhancing risk management practices in response to the unique challenges of climate and environmental risks. NCAs are recommended to apply the guidelines to less significant institutions proportionate to business models and risk profiles. As one of the first NCAs, the German BaFin has already expressed its point of view on market practices for the management of sustainability risks in a broader context of sustainability, covering not only environmental aspects but also social and governance aspects for the financial sector including banks, insurers and asset managers[4].

Overview of key expectations

The ECB’s expectations on the management of climate-related and environmental risks are anchored in the existing prudential framework as set out in the CRD/CRR package and supporting EBA technical standards. The 13 principles cover the full operating model from strategy through embedding in key risk and business processes and disclosure.

  • Strategy and risk appetite. Climate and environmental risks are expected to be a key consideration in setting strategies and business plans, as well as the institution’s risk appetite. This includes the expectation of considering medium- and longer-term time horizons, constituting challenges for existing practices and methodologies.
  • Governance and accountabilities. The guidelines recognise the importance of the ‘tone from the top’, with a clear expectation to place climate and environmental risks firmly on the management board’s agenda. Cognisant of the emerging organisational set-up in response to these risks, institutions are asked to consider how to apply the three lines of defence framework as part of this journey.
  • Risk Management. While recognising that risk management practices and the methodological toolkit are still under development, there is nonetheless a firm expectation for climate-related and environmental risks to be embedded across the enterprise risk management framework. The ECB directly sets out expectations for principal risk categories (credit risk, market risk, operational risk and liquidity risk), with a focus on enhancing key decisioning and analytical processes as well as reviewing and, where relevant, expanding existing contingency planning arrangements. There is further an explicit expectation to embed climate and environmental risks in the ICAAP, raising some interesting methodological challenges given the thematic nature and longer-term time horizons.
  • Stress testing and capital planning. In line with emerging practices for the supervision of the stability of the financial system, physical risks and transition risks need to be integrated in stress testing and capital planning processes. Current capabilities will need to be expanded to enable the evaluation of longer-term scenarios and capture the full thematic breadth of climate and environmental risks.
  • Climate Risk Data and Reporting. The ECB highlights the importance of climate risk data, data governance and the ability of institutions to aggregate and adapt such data for reporting purposes. Management information is expected to be enhanced to provide management with meaningful analytics on climate-related and environmental risks to support informed decision-making.
  • Regulatory disclosures. In line with Pillar 3 transparency requirements, the ECB expects institutions to provide external stakeholders with adequate disclosures in respect to their exposure to material climate-related and environmental risks, risk management practices and related key metrics. In this context, the ECB relies on the Recommendations of the Task Force on Climate-related Financial Disclosures (TCFD)[5].

Enhancing current practices to comply with these guidelines is expected to be a considerable challenge across the market. In particular, the complexity of the system under consideration, the “historical” focus of the current methodological toolkit and the longer-term time horizons will require fundamental enhancements to the conceptual design of key components of the risk management framework.

The integration of climate-related and environmental risks into the established risk types requires the development of meaningful “translation mechanisms”, which may involve the identification and assessment of previously unknown risk factors. Another topic of particular complexity is building out capabilities underpinning long-term projections of the institution’s business model when it comes to estimating and quantifying the outside-in impact of comprehensive, long-term climate-change scenarios.

Conclusion and next steps

The ECB’s guidelines are a useful waystone on the journey to defining the financial system’s role in the transition to a sustainable future – as well as how existing risk management frameworks need to evolve.

In line with the ECB’s expectations for the end of 2020, we see a number of sensible steps to be taken in the coming months (recognising the challenges of dealing with the current Covid 19 situation):

  1. Perform an initial gap analysis across the principles articulated by the ECB to identify key gaps against current practices
  2. Define a target state and road map for implementation, taking into account the institution’s strategy and expected changes to the business and operating environment
  3. Identify material climate and environmental risks and mapping these to risk categories, business lines and impact assessments

We have developed frameworks and approaches to support financial institutions in tackling these initial challenges and building required enhancements across the enterprise risk management framework. In subsequent blog entries, we will set out how to map climate and environmental risks into the existing risk taxonomy, as well as required enhancements to key concepts and processes such as risk appetite.

 

[1] ECB guide on climate-related and environmental risks: https://www.bankingsupervision.europa.eu/legalframework/publiccons/html/climate-related_risks.en.html

[2]The Paris Agreement: https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement

[3]Commission action plan on financing sustainable growth: https://ec.europa.eu/info/publications/180308-action-plan-sustainable-growth_en

[4] Guidance Notice on Dealing with Sustainability Risks: https://www.bafin.de/SharedDocs/Downloads/EN/Merkblatt/dl_mb_Nachhaltigkeitsrisiken_en.html

[5] Recommendations of the Task Force on Climate-related Financial Disclosures: https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf

 

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WP Dr. Michael Rönnberg

Telefon    +49 69 9585 1524

Mobil       +49 160 9101 4011

michael.roennberg@pwc.com

Johannes Goldner

Telefon    +49 69 9585 2528

Mobil       +49 175 607 4065

johannes.goldner@pwc.com

WP Daniel Benzing

Telefon    +49 211 981 2124

Mobil       +49 175 295 4264

daniel.benzing@pwc.com

Dr. Tim-Oliver Müller

Telefon    +49 69 9585 5816

Mobil       +49 170 709 6260

tim-oliver.mueller@pwc.com

 

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