Banks— managing the financial risks of climate and environmental change

Regulatory expectations around climate-related financial risk continue to be a significant concern for banks. There are already challenging requirements which form part of “business as usual” supervisory cycles for the ECB (as well as other supervisors such as the PRA). Supervisors have made it clear that, where banks fall short, they can expect sanctions, and the ECB has begun to put this into practice. Regulatory policy in this area continues to be a topic for discussion and is expected to evolve as climate risk modelling approaches and banks' capabilities mature.

The ECB's 2020 Guide on climate and environment-related risks has already been updated in parts and recent speeches suggest that further enhancements are likely. The EBA is consulting on proposals that would deliver under its CRR3 and CRD6 climate and environment-related mandates. At a global level, the BCBS continues to explore climate and broader sustainability impacts, and the FSB's 2024 workplan continues its work on coordinating international efforts to address climate-related financial risk. 

In this article, KPMG looks at ten areas where banks are likely to see continued focus or new developments in 2024.

The EBA's consultation (PDF- 608KB) on draft guidelines on the minimum standards and reference methodology for the identification, measurement, management and monitoring of ESG risks offers insights into the likely direction of travel. The consultation is the start of the process to deliver the EBA's climate risk mandates under the amended Capital Requirements Regulation (CRR3).

The EBA notes that banks should consider the role of ESG risks as potential drivers of all traditional categories of financial risks, including credit, market, operational, reputational, liquidity, business model and concentration risks. It also sets out more granular expectations including:

• Time horizons for materiality assessments: less than three years for short-term, three to five years for medium-term, and at least 10 years for long-term.
• Specific data sets that banks should obtain from their large corporate counterparties for climate and environmental risks: geographical location of key assets and exposure to environmental hazards, current and forecast scope 1, 2 and 3 GHG emissions, material impacts on the environment, dependency on fossil fuels, energy and water consumption, litigation risk, and transition plans.

Requirements for banks' internal procedures around principles for measurement and assessment to provide for a combination of methodologies including exposure-based (for a short-term view on credit risk profile), portfolio-based (to support medium planning and definition of risk limits / risk appetite) and scenario-based (to assess sensitivities across different time horizons, including long-term), specifying key risk indicators that need to be considered in each methodology.

Again, the EBA consultation is a helpful pointer. Banks will be expected to embed ESG risks within their standard risk management systems and processes, incorporate them into the ICAAP and ILAAP, and ensure consistency with overall business and risk strategies. This is not new per se, and echoes earlier messaging from the supervisor, which noted that effective practice would include having a well-defined quantitative risk appetite statement (RAS) aligned to the overarching risk management framework (RMF). 

Supervisors have published many findings in this area, including a recent discussion paper from the BCBS on the role of climate scenario analysis in strengthening the management and supervision of climate-related financial risks.

Banks should expect further focus on:

• Decision-useful scenario analysis, e.g. running scenarios that can help in making credit decisions.
• Use of scenario analysis to test the adequacy of their strategic response to climate change risks, e.g. by quantifying the impact of scenarios on profits and losses, risk-weighted assets and regulatory capital. 
• Extending macro scenarios provided by bodies such as the NGFS and tailoring them to provide relevant asset-level analysis.
• Ensuring that management actions resulting from scenario analysis are credible and can be executed in a stressed environment, even where other market participants are likely to be implementing similar actions.  
• Efforts to overcome data limitations when running scenarios, including using client and counterparty data held by the bank rather than relying on proxies.  
• Evidence of why selected data and assumptions are appropriate to a firms' specific business vulnerabilities. 

In the EU, as well as in other neighboring jurisdictions (e.g. in the UK), further work on the integration of ESG risks in the prudential framework is expected.

In the meantime, the current approach, whereby climate-related risk is captured under Pillar 2 as part of the ICAAP (and monitored during the Supervisory Review and Evaluation Process (SREP)), will continue. 

In the current EBA consultation there is no mention of specific climate capital requirements — instead the focus is on managing risk across traditional financial risk types and using the ICAAP to capture material risks. 

However, climate capital still forms part of the Basel Committee's workplan. In December 2022, it published FAQs on how banks could reflect climate risk in Pillar 1, and committed to publishing additional information as data availability and methodologies matured. The 2023/24 workplan  showed continued focus on assessing climate-related gaps in the Basel framework, so the debate is far from over.

In the wider sphere of sustainability regulation, reporting and disclosures have been a key driver of regulatory pressure for firms across financial services — as reflected in the latest edition of the KPMG Regulatory Barometer. However, the reputational risks involved in making misleading sustainability claims (greenwashing), whether deliberate or not, and the associated litigation risk, can all translate into prudential impacts. Banks in the EU will already be familiar with the ECB's workplan of deep dives on reputational and litigation risk, and are expected to further deep dive in the topic given a.o. the increasing focus on greenwashing by regulators including  the EBA (PDF-1.496MB).

The EBA was mandated to develop granular climate related disclosure requirements, and has done so under its Pillar 3 ESG ITS. In parallel the BCBS recently consulted on Pillar 3 templates for banks to disclose qualitative and quantitative data such as exposures by sector, financed emissions and exposures subject to physical risk by geographical area. The PRA is responding to the BCBS Pillar 3 consultation, as confirmed in its latest Business Plan — it would be likely to adopt any final BCBS recommendations but will be interesting to see how any decisions on this might be influenced by the secondary competitiveness and growth objective.

The ECB already includes environmental-related risks in its prudential expectations. It has added a new workstream to its 2024/25 workplan to focus on the risks stemming from nature loss and degradation and how they interact with climate-related risks. The PRA does not currently set out any specific requirements on nature-related risk. However, the FCA's 2024-25 Business Plan referred to a “nature” regulatory principle coming into force, and a report is expected in April from the Green Finance Institute, providing a “first-of-its-kind UK Nature-Related Risk Inventory” that will estimate the dependency of UK banks and insurers on ecosystem services and present a methodology to translate these dependencies into financial risk. Additionally, the Global Association of Risk Professionals (GARP) published its first global survey on nature-related financial risks, finding that there is increasing focus on nature but firms’ maturity levels on strategic engagement is relatively low.

This has already begun. In a recent speech, Frank Elderson, ECB Board member, warned that banks failing to meet supervisory expectations on C&E risks would face a penalty for every day that shortcomings remained unresolved. Letters have been sent to individual banks and these penalties are now being applied.

A key challenge for banks in climate risk modelling is the lack of a granular industry or regulatory standard on approaches and assumptions. This leads to variation in the level of sophistication of climate risk modelling approaches, making it difficult to compare risks across the industry, and a possibility that key exposures are being under- or over-estimated across the sector. Banks are making their own decisions on how to develop their modelling, including on issues such as dynamic balance sheet models, factoring in second-order effects such as impacts on supply chains and developing bespoke climate risk scenarios. It will be interesting to see if prudential regulators introduce granular expectations on modelling approaches and assumptions beyond the high-level expectations already published.  

Supervisors are also looking at modelling capabilities that can assist in their analysis of climate-related risk. Project Gaia has been developed by the Bank of International Settlements (BIS) partnering with the Bank of Spain, the Deutsche Bundesbank, and the ECB. Gaia is an artificial intelligence (AI) application that uses large language models to search and extract data from corporate climate-related disclosures, enabling quick and efficient analysis of climate-related risks in the financial system — the recent report (PDF- 6.7MB) on the project included analysis of 20 key performance indicators (KPIs) for 187 financial institutions over five years. One possible next phase of Project Gaia is to make the tool publicly available to analysts to support the growing demand for climate-related data. Banks should expect supervisors and analysts to make increasing use of such models to gauge the potential systemic financial risks of climate change.

In the EU, acceleration of the effective remediation of shortcomings in governance is one of the ECB’s supervisory priorities for the next two years. This encompasses not only the functioning of banks’ management bodies, but also their risk data aggregation and reporting capabilities. Given that ECB-supervised banks should have embedded climate and environment-related risks in their governance, strategy, and risk management by the end of 2023 at the latest, they can expect these risks to be included as part of BAU governance reviews.

KPMG in Belgium has a dedicated Risk & Regulatory practice with extensive ESG and sustainability expertise in the Financial Sector. For more information, and to discuss your requirements, please get in touch.