Banks— managing the financial risks of climate and environmental change

1) More prescriptive expectations on the quantification of ESG risks

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:

4) Climate capital to remain under Pillar 2 rather than be mandated under Pillar 1 — for now….

The Bank of England's 2023 report on climate-related risks and capital concluded that further work was required to assess whether there was a regime gap in the macro prudential framework. If such a gap is identified, further consultation will be required on the best way to address it before mandating any capital requirements. In the meantime, the current approach, whereby climate-related risk is captured under Pillar 2 as part of the ICAAP, will continue. 

This is consistent with the EU approach, with the ECB setting Pillar 2 capital requirements as part of the Supervisory Review and Evaluation Process (SREP). In the current EBA consultation (see above) 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.

5) Increased focus on the prudential impacts of greenwashing

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. Given increasing focus on greenwashing by other regulators including  the EBA (PDF-1.496MB) and the FCA, it would seem logical for the PRA to also expect banks to assess, manage and mitigate the potential impacts of greenwashing accusations e.g. litigation and reputational risks.

7) Reflecting nature and wider ESG risks in prudential expectations

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. Given increasing emphasis in this area, it is reasonable to expect that the PRA may move on this — potentially as part of the review of SS3/19.

8) More stringent penalties

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. In its 2022 supervisory priorities letters for UK deposit takers and international banks, the PRA highlighted the ‘range of supervisory tools under review for use where we deem progress to be insufficient’. As the PRA reviews SS3/19, it may start to take a stronger stance. Banks should not underestimate how serious supervisors are.

9) Novel approaches to climate risk modelling

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 too are 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.

10) Enhanced governance expectations

While not specific to financial services, the updated UK Corporate Governance Code (PDF-399KB) will require boards to not only monitor a company's risk management and internal control framework but also explain how they have measured its effectiveness through a declaration in the annual report. Banks will want to consider how these requirements will reflect their work on climate-related risks. 

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.