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On July 8, 2022, the European Central Bank (“ECB”)
released the results from its annual stress tests, this year
focused on banks’ ability to incorporate climate risk stress
testing into their risk management frameworks. The report found
that most banks have not developed the adequate processes to
incorporate climate risks into their stress-testing framework. The
ECB will not issue any immediate binding decisions on banks. The
ECB performed the review as a learning exercise, in which they will
take the results and incorporate them into their upcoming guidance.
The report highlights several areas of concern for the ECB. A
significant area of concern for banks is the lack of
climate-related data available to credit institutions. These areas
of concern foreshadow future regulations from the ECB and banks
should begin to review their stress-testing frameworks and improve
climate data collection processes in response to the predicted ECB
rulings.
OVERVIEW OF RESULTS
Overall, the ECB reported that banks have made progress in their
climate stress-testing abilities, but a majority of banks do not
adequately incorporate climate risk into their risk management. The
ECB conducted the review in three modules that look qualitatively
and quantitively at how banks incorporate climate risks into their
stress tests and how exposed banks are to the transition and
physical risks of climate change. The ECB found that a majority of
banks do not use a climate stress-testing framework. Banks that
lack this framework often did so because they do not have enough
data to adequately make the risk projection. Although banks are
heavily exposed to climate change-related risks, the level of
exposure is varying between the types of different banks.
EXPLANATION OF METHODOLOGY
The ECB conducted the assessment as a “bottom up”
review. Applying data provided by the banks, the ECB conducted the
tests in three modules.
Module 1
Module 1 involved a qualitative questionnaire that aimed
at assessing the banks’ climate stress-testing frameworks. The
questionnaire included asking banks about their appetite for risk,
integration of climate stress tests into their overall business
strategy, and future plans for climate stress tests. The goal of
this module was to provide for a uniform assessment of banks’
climate risk stress-testing frameworks.
Module 2
Module 2 required that banks provide a granular breakdown of their
income (two-digit level), using the NACE (Statistical
Classification of Economic Activities in the European Community).
In addition to this breakdown, banks also had to report their 15
biggest non-SME (non-small and mediumsized enterprise) corporate
exposures for each high climate impact sector as defined by the
Technical Expert Group on Sustainable Finance (“EC
TEG”).
Module 3
For Module 3, banks had to provide projections for how they would
fare under different climate scenarios and risk areas.
These projections were all done over a 30-year time range, and
banks would assume a dynamic balance sheet that would change over
this time horizon. For physical risks, banks were asked to provide
credit risk projections under a drought, heat and flood risk
scenario, and projections for how their balance sheets would fare
in different transition scenarios based on possible climate policy
paths and timelines. Under a longterm (30 years) period, banks had
to provide projections under three different policy paths. The
paths were: (i) an orderly transition; (ii) a delayed, disorderly
transition; and (iii) a “hothouse world” with unchanged
policies.
In the orderly scenario, the ECB assumes that climate policies
are introduced early on and gradually become more stringent. The
scenario further assumes that global warming is limited to
1.5°C based on climate policies and innovation and netzero
carbon emissions are reached by 2050. The orderly scenario
minimizes the costs resulting from the energy transition, and the
low amount of warming lowers the physical risk of climate
change.
In the disorderly scenario, the ECB assumes that new climate
policies are not introduced until 2030. As a result, deciders make
more drastic and rapid policy changes to limit warming to below
2°C. This scenario results in carbon prices spiking due to
policymakers’ constraint to more drastically address climate
change. Since the warming is higher, banks must also deal with
higher physical risks of climate change.
In the “hothouse scenario,” no new climate policies
are implemented, and warming increases to 3°C. Because no new
policies are implemented, banks do not have to cope with transition
risks. However, the increased warming creates a large amount of
physical risks that banks will see in the second half of the 21st
century.
The ECB emphasizes the importance of how carbon pricing is
affected by the different scenarios. In the orderly scenario, the
carbon price starts at a high level and gradually increases. In the
disorderly scenario, the price starts at low amount, but
policymakers have to increase it rapidly to meet the climate goals.
In the hothouse scenario, carbon pricing stays at a low level. The
price of carbon is an important driver of the transition costs.
Banks also had to make projections under short-term, three-year
scenarios that consisted of a front-loaded, disorderly
transition.
FINDINGS
Stress-Testing Capabilities
The ECB found that banks had improved their stress-testing
capabilities since the last review in 2021. The percentage of banks
that performed a climate-related stress test sat at 25% in 2021,
but in the 2022 climate stress test, the percentage rose to 40%.
However, the ECB noted that while the improvement deserves praise,
40% still means that more than half of banks do not incorporate
climate risks into their stress tests. Additionally, 40% of the
banks with climate stress-testing measures do not incorporate the
results of the tests into their business strategies.
Other findings include:
- Sixty percent of banks with a climate-risk stress-testing
framework do not currently disclose or intend to disclose any
results of the stress tests. - Ninety-three percent of banks with climate stress-testing
frameworks have developed a validation process. However, 75% of
them do not ensure independence between the development and
validation processes, as the same business unit is responsible for
developing and validating the data. - Forty percent of banks with a climate-risk stress-testing
framework already in place do not currently involve the internal
audit group in reviewing the framework. - For risk types, 71% of banks with a climate stress-testing
framework include at least physical or transition risk in the
scenarios they consider. Eighty-one percent of the banks consider
transition risk. Only 24% consider liability and reputational
risk. - Thirty-seven percent of banks with a climate stress-testing
framework in place include only between one and two balance sheet
climate-risk transmission channels. Thirty-five percent include
only between one and three portfolios (e.g., corporate loans,
retail household loans, etc.). For modeling of climate risk, only
22% of the banks apply or are considering applying a dynamic
balance sheet approach for both transition and physical risk. - Around 75% of banks that have a climate stress-testing
framework in place report that climate-related and environmental
events are included in their operational-risk stress-testing
scenario analysis. For reputational risk, less than 40% of the
banks indicate that climate-related and environmental events are
included.
Findings Related to Enhancing their Climate-Risk
Stress-Testing Frameworks
- Fifty percent of banks that currently do not have a climate
stress-testing framework in place indicate that they need at least
one to three years to incorporate physical and/or transition
climate risk into their stress-testing framework.
Banks’ Exposure to Climate Risks
- On average, 60% of the surveyed banks’ interest income came
from business with nonfinancial corporate entities that belonged to
22 carbon-intensive sectors. Development banks/promotional lenders
tended to be more reliant on these carbon-intensive businesses,
while custodians, asset managers, and globally systemically
important banks were less reliant. The reliance on these
carbon-intensive industries exceeds the industries’ relative
weight to the EU economy as a whole. - The combined weight of the seven most greenhouse gas
(“GHG”)-emitting sectors represents on average 28.8% of
nonfinancial corporate exposures for banks related to the 22 NACE
sectors considered in the relevant module.
Banks’ Ability to Withstand Climate Change
Scenarios: Transition Risk
- In the short term, banks are vulnerable to a non-negligible
increase in credit risk impairments. However, banks are better
equipped to incorporate short-term climate risk into their
risk-management framework. - In regard to long-term projections, losses were the lowest in
the orderly transition scenario. Where they were lower than in the
scenarios was where the transition was delayed or did not
occur. - Banks’ exposure to the real estate industry is especially
vulnerable in the flood risk scenario. This is because of the
expected drop in real estate prices in areas at risk for
flooding. - Banks with large exposure to outdoor, labor-intensive sectors
are the most vulnerable to drought and heat. The drought and heat
scenarios forecast an overall decrease in sectoral productivity.
The decrease is significantly higher in outdoor, labor-intensive
sectors such as agriculture and construction. - The specific physical risks depend on location. High heat and
drought are a larger issue in the Mediterranean area than in the
north of Europe. Physical risks stemming from floods depend on the
geography of the area and vary significantly within a country.
Additionally, the physical risks associated with flooding and
heat/drought are different. Flooding heavily affects real estate,
while drought/heat most negatively affects outdoor, labor-intensive
industries such as agriculture and construction.
Takeaways for Banks
How should banks respond to the findings in the report? First,
banks should be aware that the ECB will use this climate stress
test as a learning exercise. The banks that participated in the
review received individualized feedback for how they can enhance
their climate stress-testing abilities and better understand the
exposure they face related to climate change.
Second, the ECB will take their findings from the climate stress
test and incorporate them into their upcoming Supervisory Review
and Evaluation Process (“SREP”). The SREP will also
consider the results from the thematic review on climate-related
and environmental risk.
Third, the ECB provided a list of best practices it sees
emanating from the findings under review. The best practices
included integrating climate risk into banks’ Internal Capital
Adequacy Assessment Process, or ICAAP, understanding climate risk
at the sector or even firm level to understand the wide range of
climate risks that different industries and businesses create, and
creating long-term plans that incorporate concrete green transition
targets. Regardless of the specifics of the suggested best
practices, banks need better climate data to manage the risks of
climate change.
Fourth, the report should be read as one part of the ECB’s
broader crackdown on environmental policy and finance. Banks’
balance sheets reflect how banks interact sustainably with the area
of climate change; at this stage, the ECB is worried that banks do
not have the data or governance structures to understand how the
two are connected.
DATA ISSUES
The ECB’s report stressed the lack of data that institutions
have at their disposal to understand how climate change would
affect their operations. Banks that did not have climate
stress-testing frameworks often reported that they did not have
enough climate-related data to perform a meaningful risk analysis.
Within banks that did have climate stress tests, the climate data
is not available to the relevant business areas. According to the
ECB, virtually all banks stated the need for better climate data.
Banks expect to remedy this issue through better data collection
from counterparties as well as engaging with data providers. When
measuring exposures, banks are subject to limited availability of
GHG emissions data. Banks then have to rely heavily on
approximation techniques and/or external providers, which may
affect accuracy and conservativeness of banks’ estimates
regarding carbon intensity.
The report states that a large number of banks rely on proxy
estimates for their climate risk-management framework. The ECB
commends this a beneficial first step for better data collection.
However, banks will need to further evaluate and invest in their
estimation methodology to ensure that the proxies are adequate
substitutes for the unavailable data.
While banks are advised to follow the ECB’s recommendations
and work with their clients to ensure more accurate data for
climate stress tests, the forthcoming Corporate Sustainability
Reporting Directive (“CSRD”) should ease this data
collection. Under CSRD, corporations have to begin reporting data
on a number of nonfinancial categories, including environmental
impact data. Unlike previous disclosure requirements that dealt
only with certain large companies, CSRD applies to all large
companies and all companies listed on regulated markets. While
certain data that the ECB noted banks were lacking for their
climate stress tests will be made public under this disclosure, the
impacted businesses will not release their first respective
disclosures until 2024, covering the year 2023. The time gap means
that banks should not wait until disclosure season 2024 for their
clients to begin making public disclosures to start implementing
climate stress tests. The almost two-year time gap is a rather
critical period banks should use to better align themselves with
the ECB’s broader climate goals, and they should continue to
work directly with customers to understand the climate risks the
bank faces.
GREENWASHING
The climate stress test results could also indirectly increase
the risk of “greenwashing” related litigation. In
general, “greenwashing” (which is a concept not yet
defined under the current legislation) involves the marketing of an
asset, security, or any other financial product as
“green” or “sustainable,” when the asset,
security, or financial product is not in fact “green” or
“sustainable.”
A party can be found guilty for capital investment fraud if it
shares incorrect information or conceals disadvantageous facts
about an investment.
The latter pathway to “greenwashing” related capital
investment fraud is a larger risk for banks following the climate
stress test. The ECB’s conclusion focuses on banks’ lack of
data to understand the climate impact of their investments and
exposures. Banks “greenwash” their products when their
marketing of their products as “sustainable” does not
match the hard “sustainable” data of the investments.
Now, should banks incorporate climate stress testing and
incorporate the necessary data, they would have grounds and data to
support how “sustainable” their products actually are.
The emphasis on climate stress testing will likely make it harder
for banks to avoid criminal and regulatory penalties associated
with “greenwashing” since authorities could leverage a
bank’s internal data used for stress testing and compare that
with how the bank markets its products. The ECB currently believes
that banks do not have enough information to understand the climate
impact of their investments and exposures. As such, the ECB’s
likely forthcoming requirements to collect climate information may
increase “greenwashing” risks on banks.
A benefit of proper climate data collection and stress testing
would be avoiding the costs of restructuring loans with
carbon-intensive industries and those most affected by high heat,
flooding, and increased risks of drought. Including climate data in
the loan-granting process enables banks to better understand the
risk embedded in their loans. Banks should involve borrowers in
this process and incorporate these risks into their lending
practices.
While not explicitly stated in the report, a likely result of
the ECB’s findings is to increase the capital requirements for
banks in order for them to withstand the economic effects of
climate change.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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