What does ESG in a bank’s risk management mean?
Climate and environmental risk are becoming increasingly noticeable in our everyday lives. So much so, that they have now become the focus of banking supervision – and not only in relation to climate stress tests. Nowadays, sustainability risks in the three areas of environmental, social and governance – or ESG for short – have become an integral part of banks’ risk management. After all, one of the main tasks of a bank is to quantify and manage risk. And ESG risks are no exception.
- ESG risks can be physical risks, such as the Ahr Valley floods in 2021. Such extreme weather events can have devastating effects on people, buildings and infrastructure but also on businesses, their economic situation and therefore their financing.
- ESG risks also include what are known as transition risks, which can occur for businesses as we transform to a net-zero economy. One way of keeping a lid on climate-damaging CO2 emissions is to make them more expensive. This is particularly relevant to sectors of the economy that consume lots of energy and produce lots of emissions. It can make their business models unprofitable. But policy requirements and changing preferences among consumers also play a role.
The challenges for banks here are the long-time horizon, the lack of past experience and the availability and quality of the data.
To what extent have banks integrated ESG into their risk management and what is the status of the regulation?
Bank have been working hard for years now to integrate ESG risks into their risk management and lending activities. The regulatory requirements are also constantly evolving. Even though the German supervisory authority and the European Central Bank have already put in place requirements as to how banks should deal with ESG risks, it is now the turn of the European Banking Authority (EBA). It has published draft guidelines on the management of ESG risks. Stakeholders were able to comment on the guidelines until 18 April 2024 and they are due to be finalised by the end of 2024.
The guidelines pursue two objectives:
- Firstly, getting banks to integrate ESG factors into their risk management and lending activities and, secondly, to have them draw up plans and targets to minimise risks from the transition to a net-zero economy and from climate change. The EBA sees this as a process and still talks in general terms about how banks and supervisory authorities are currently in an early phase. The whole thing is still a work in progress. Nevertheless, the guidelines go into quite some detail on individual points. They set out specific methods and processes, which could restrict innovation and banks’ freedom to choose their own preferred method. In addition, an assessment of ESG risks is not only required for the short and medium terms, but also for the long term over a period of more than ten years. Banks will have to check to what extent ESG risk is material. To do this, the EBA has assumed that they are largely exposed to transition risks from certain sectors. One example where that doesn’t work is the energy sector, where no distinction is made between the risks from a solar farm and those from a coal-fired power plant. Reversing the burden of proof makes a mockery of the risk assessment.
- Another completely new and very extensive requirement is the obligation to set specific ESG risk targets and to compile a supervisory (prudential) transition plan.
What is a transition plan and what is the EBA requiring banks to do here?
A business or a bank uses a transition plan to outline what measures it will employ to ensure that its business model and strategy are compatible with a net-zero economy and climate goals. And their reference point is often the Paris climate agreement objective to limit global warming to a maximum of 1.5°.
Such transition plans are required by both bank specific EBA guidelines on ESG risks and general regulatory initiatives such as the upcoming Corporate Sustainability Due Diligence Directive (CS3D). The CS3D applies to businesses with more than 1,000 employees and a turnover of more than 450 million euros.
Businesses and banks that have a transition plan need to report on it as part of their sustainability reporting in accordance with the Corporate Sustainability Reporting Directive (CSRD). This gives investors and the general public an insight into the planning and measures being taken by the business. For banks, such plans are becoming increasingly important for their lending business. They help them understand how their customers are helping to transform the economy.
However, there is a crucial difference with the transition plans now required according to the EBA guidelines: they are geared towards risk, which is why they are also called prudential transition plans. It is not yet fully clear what the content of these plans should look like in detail. Based on the EBA guidelines, they would include outlining internal bank processes to identify, measure and control ESG risks as well as goals to reduce ESG risks. The latter would mix strategic with risk-related aspects.
How banks currently see the EBA guidelines is outlined in the German Banking Industry Commission’s position paper from 18 April 2024.
