December 23, 2021 | Ali Abbas
Estimated reading time: 6 minutes
ECB report finds ‘long way to go’ for managing climate risk in finance
The European Central Bank (ECB) has said that financial institutions still have a “long way to go to fully align their practices with supervisory expectations” for climate risk.
In a recent report, The state of climate and environmental risk management in the banking sector, the ECB revealed the results of its comprehensive assessment of the state of play for climate-related and environmental (C&E) risk management in the banking sector”. The report, which is the first of its kind from the ECB, is a supervisory review of the way in which banks are managing such risks and paints a picture of challenge and unpreparedness.
The making of the report
In November 2020, the ECB published a Guide to C&E risks. The guide set out 13 expectations for financial institutions to consider when creating business strategies and implementing governance and risk management frameworks. This guidance was published with a view to making businesses more transparent about their C&E risk disclosures, and to encourage them to be proactive about risk management.
The ECB asked 112 “significant organizations” within financial services to self-assess their current practices against the 13 expectations set out in their Guide and submit plans explaining comprehensively how they would look to introduce processes to tackle C&E risks. This latest report explores the submissions of these 112 institutions.
The findings of the report
Institutions are not close to aligning their practices with supervisory expectations
Of the 112 participant organizations, the ECB did not find a single one to be close to aligning with supervisory expectations for C&E risk management. While some institutions had taken considerable steps towards adapting their practices to consider such risks, this was mainly apparent in the largest of financial institutions.
On the whole, most participant organizations were in their early stages, with 90% admitting that their practices were only partially aligned with the ECB’s supervisory expectations. Of these 90%, some organizations said that their practices did not meet the ECB’s expectations “at all”. Despite this, however, most firms were aware that they needed to improve their management and disclosure practices around C&E risks.
Climate risks are evolving, which doesn’t make things easy
The ECB noted that many firms find it difficult to tackle C&E risks because they are generally transient and subject to constant change. These risks are evolving frequently, which makes it difficult for organizations to integrate them into more permanent strategies, governance and risk management. The ECB understands this challenge and has committed to a “continuing dialogue” with institutions to help them manage and strengthen risk management in these less sedentary areas.
Nearly all participants expect C&E risks to materially affect their risk profiles
Almost all of the participant organizations in the ECB’s report have said that they expect C&E risk to have a material impact on their risk profile in the next three to five years. Around half of participants expect there to be an impact in the short-to-medium term. Across all risk profiles, organizations said that they expect credit risk, operational risk and business model risk to be the most sensitive to issues brought up by climate and environmental changes.
Policies and procedures are changing, but strategies remain the same
The report found that organizations are working proactively to adapt and amend internal policies and procedures to account for emerging C&E risk. However, despite this proactivity, very few institutions have put C&E risk practices in place that have a clear impact on their strategy and risk profile.
Participant organizations said that their management bodies are increasingly taking on formal responsibilities for C&E risks, however the majority of institutions have not provided their management with the tools they need to do this adequately, including the provision of relevant risk reports.
There’s a dearth of data, or a lack of trying
There similarly appears to be a dearth of data around C&E risks, or rather a lack of effort to obtain such data. The ECB’s report highlights that very few institutions have looked at, or indeed “made any effort at all” to take stock of the type of data they may need to identify and successfully report on internal C&E risks.
Despite this lack of effort, “lack of available data” is frequently given as a reason why firms have made insufficient progress with incorporating C&E risks. More than half of participant organizations said that they had no actions planned to embed C&E risks into their business strategies.
Organisations plan to improve, but the standard of those plans is inconsistent
The report finds that nearly all participant organizations have developed implementation plans to improve their practices, but the quality of these plans is not consistent across the board. The ECB expects institutions to produce plans that show a clear roadmap, with milestones as well outlining robust processes for implementation and monitoring. Despite this, some institutions provided plans that were too brief, unsubstantiated, or too large containing documents detailing every action they planned over time.
What does ‘good’ look like?
Despite finding that financial institutions were generally lagging behind with plans for managing climate and environmental risk, the ECB report does highlight some areas of good practice. These include:
- On the topic of business models, one institutions has developed practices that integrate C&E risks into its strategic planning while applying ‘double materiality’ concept of the European Commission’s Guidelines on non-financial reporting. Meaning that it assesses the impact of C&E risks on both its business environment (financial materiality) and the impact of the group’s activities on the environment (environmental materiality).
- On the topic of governance and risk, one institution has implemented comprehensive governance arrangements involving the management body by setting up dedicated sub-committees and departments for C&E-related commitments.
- Sticking on the topic of governance and risk, a number of institutions have developed an approach for establishing a reporting framework for C&E risks.
- With regard to risk management, one institution has fully embedded transition and physical risk for C&E into its asset allocation process.
- On disclosures, one institution has developed a dedicated policy framework for C&E risk disclosures, which describes how its disclosures are drawn up and the definitions underpinning its disclosure policy.
Overall, the ECB’s report found more areas for improvement than areas of excellence for C&E risk management. Given the challenges that the climate and environmental change presents, this is not wholly surprising.
It’s interesting to see that many firms attribute a lack of available data as the reason for their lack of action in incorporating C&E risks into their internal frameworks when, on the other hand, the ECB has found that a number of firms had made no effort at all to take stock of that data they might need. In some respects it’s a chicken-egg situation: is there a lack of data, or are firms simply not trying? Or, alternatively, are firms not trying because they know (or expect) that the data isn’t out there.
One of the data issues for C&E – which similarly runs across all of environmental, social and governance (ESG) data – is that it is almost impossible to place rigid parameters around the topic. As the ESB acknowledges above, the definitions and risks within C&E are ever-evolving. Firms may be waiting for a standard data set, definition – or even just one firm to publicly take the plunge into the known for C&E risks.
Whatever the reason, the ECB notes that progress is slow, with the expectation that many institutions will not have practices in place that are aligned with the ECB supervisory expectations in the near future. In fact, more than half will not have completed plans by the end of 2022 and some firms have no short-term deliverables in place. Perhaps then, it should be incumbent on the regulators rather than the financial organizations to set perimeters for C&E or ESG? If there were more clarity, no doubt firms would be less hesitant to tackle these transient areas.
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