This is the second article out of a series of articles covering the essence of EBA roadmap that constitutes guidelines related to the final milestones of the Basel 3 framework. In this article, we will discuss the (draft) guidelines that aim to formalize the approach to the identification, measuring, management, and reporting of Environmental, Social, and Governance (ESG) risks in the EU banking sector. 

Recent Developments in ESG Management (A brief Summary) 

ESG risks, unlike any other category of risk, are still at their inception stage, to be incorporated by banks into their (regulatory) risk models. Moreover, the specificities of these risks’ distinctive impacts over multiple time horizons, their forward-looking nature as well as extremely limited historical event data, may create significant tangible differences in the measurements and management practices of such risk compared to the traditional ones.  

Since the exposure of this category of risk has the potential to impact all the other traditional ones, not taking them into account would pose as a bigger threat than the transition risk drivers affecting these institutions. Therefore, the resilience and sustainability of business models as well as the respective risk profile of banks has become crucial for their survival in the short, medium, and the long-term. 

Recently, EBA has recently released a consultation paper with a set of draft guidelines for ESG risk management and the internal processes that institutions need to have in place.  

Before we go deeper into the guidelines, let’s assess the expectations of the EBA towards banks: 

• Using sound data processes and a combination of technologies such as exposure-based, portfolio-based, and scenario-based methodologies, institutions should make sure that they are able to diligently identify and measure ESG risks.  
• Institutions should make an active effort to integrate ESG risks in their routine risk management framework by considering their role as potential drivers of all traditional categories of financial risks.  
• Institutions should employ effective internal reporting frameworks as well as a set of backward and forward-looking ESG risks metrics and indicators, to comprehensively monitor these risks. 
• 1. The content of the plans shall include specific timelines and intermediate quantifiable targets and milestones. This is done to monitor and address the financial risks stemming from ESG factors, including those arising from the process of adjustment and transition trends towards the relevant Member States and Union regulatory objectives in relation to ESG factors. Keeping CRD prudential regulations in sight, institutions should develop the transition plans to address these risks arising from the transition adjustment process towards regulatory objectives based on ESG factors of their own jurisdictions. Keeping this in consideration, these institutions should embed forward looking ESG risks considerations in their strategies, policies and risk management protocols by transition planning considering various time horizons.

Subject matter, scope and definitions

In accordance with Articles 87a(1) and 74 of Directive 2013/36/EU, the guidelines specify robust governance arrangements that institutions are needed to have in place. Furthermore, these draft guidelines cover 3 areas: 

1. Minimum standards and reference methodologies for the identification, measurement, management, and monitoring of ESG risks.

2. Qualitative and quantitative criteria for the assessment of the impact of ESG risks on the risk profile of the institutions in the short, medium, and long term.

3. The content of the plans shall include specific timelines and intermediate quantifiable targets and milestones. This is done to monitor and address the financial risks stemming from ESG factors, including those arising from the process of adjustment and transition trends towards the relevant Member States and Union regulatory objectives in relation to ESG factors. 

 Reference Methodology  

1. Identification and measurement of ESG risks
   

• Materiality assessment: When it comes to the identification and measurement of ESG risks being included by the institutions in their strategies and internal protocols (as part of the reference methodology), a frequent (at least every year) regular performance of the materiality assessment of ESG risks must be provided. For the small and non-complex institutions (SNCI), this could be performed every two years based on any material change to their business environment with respect to the ESG factors.  
• Identification and measurement activities of ESG risks: The institutions will be required to capture the aspects of identification, collection, analysis and structuring of the necessary data and information, in their internal procedures as part of minimum standards to identify and measure ESG risks.  

 2.  Management and Monitoring 

 As part of the new standards, the EBA emphasises on multiple aspects for the management and monitoring of the ESG risks. These aspects include the following: 

• ESG Risk Management Principles: Institutions should consider the role of ESG risks as potential drivers for all the other traditional categories of banking risks. Therefore, institutions should embed the technicalities of the ESG risks within their regular risk management and monitoring systems.  
• Strategies and Business Models: As a part of designing their short-term and long-term business goals, institutions should be mindful of the effects of ESG risks on their overall business and risk strategies.  
• Risk Appetite: Institutions need to carefully assess ESG risks as part of defining their overall risk appetite that includes both their portfolio concentration and diversification objectives. The risk appetite needs to be enforced with considering relevant ESG-related Key Risk Indicators (KRIs) that may include potential limits, thresholds or exclusions.  
• Internal culture, capabilities, and controls: As part of their training policies, institutions should make sure that their staff as well as the management team are well-versed with the implications of ESG risks as part of fulfilling their responsibilities effectively.  
• ICAAP and ILAAP: As part of their assessment of the solvency and liquidity impact for varying time horizons, institutions should integrate the material effects of the ESG risks into Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP) as part of both their regulatory and economic perspectives.  
• Credit Risk Policies: Institutions should maintain prudent, articulate processes to identify, measure, monitor, manage, and monitor the relevant impacts of the ESG risks on the credit risk aspects. The EBA has already set guidelines for integrating ESG risks in credit risk policies, as mentioned in the guidelines on loan origination and monitoring.  
• Monitoring: The process of monitoring ESG risks by institutions should be conducted by employing effective and comprehensive internal reporting frameworks that convey as much information pertinent to the institutions’ risk profile as possible.   
   

ESG Reporting and Disclosures (Pillar 3) 

Prior to releasing the consultation paper discussed above, the European Banking Authority (EBA) has published the ESG prudential disclosure templates (Pillar III). The disclosure templates primarily contain the data fields related to the qualitative information that has been further classified into three categories for each factor; Business strategy and processes, governance, and risk management. However, it is noteworthy that these published templates contain multiple sections of disclosure data fields related to the climate risk aspect of the ESG as well. Moreover, since the climate risk had not been adequately covered in the previous publications by the EBA, this set of templates covers multiple areas of exposure related to both the transition risk and physical risk as an overall section of the climate risk activity. Moving further, the templates also cover the Green Asset Ratio as per EU Taxonomy regulation.  

Principles on climate-related and environmental risks 

The ECB in February 2024 released another consultation paper on revision of the guidelines for internal models. In addition to all the other risk categories, the principles on climate-related and environmental risks have also been mentioned in the context of calculating the own-funds requirements. The guidelines emphasise on the inclusion of the climate-related and environmental risks wherever possible, for calculating the risk estimates such as PD and LGD. In cases where there is absence of sufficient information of these risk drivers, an override approach (ECB defines override as a judgment-based and discretionary action that contributes to the assessment of the obligor’s creditworthiness) shall be used to account for these climate-related risk for calculating the requirements of own funds.  

 Conclusion

The prevalence and the growing significance of ESG risks facing the banking industry cannot go overlooked anymore and the imminent need for planning and implementing safeguards along with the necessary protocols related to reporting and disclosing ESG risks is imperative. Though the outcome of the consultation paper is still unknown, the direction of approach of the EBA regarding the ESG factors suggests that the official definition term ‘sustainability’ of a bank will gradually become increasingly comprehensive and wider in its scope over the coming years.  

Furthermore, the component of climate risk under the ESG framework is still new and evolving, and the banking sector continues to explore how to account for such risks. Currently, there is no widely accepted methodology for capturing such risks. However, it does not mean that the banks should not plan for capturing such risks in the future.  

The resilience of the banking sector is not only essential for banks and its stakeholders, but also for the external environment that it operates in. The extent of impact of the activities of these banks needs to be controlled. Furthermore, the climate risk impact on countries, especially The Netherlands, is significant, since 26% of the land of this country is below the sea level.  

Why Mount Consulting? 

Mount Consulting provides consultancy services in finance and risk to the major institutions in The Netherlands. With our vast background in regulatory frameworks, including  EU Taxonomy, SFDR, CSRD and ESG data vendor selections, we have ample experience in analysing, designing and implementing processes and solutions for ESG and sustainability reporting.