ECB Issues Financial Institution’s Best Practices for Implementation of Climate and Environmental Risk Management
On November 22, 2021, the European Central Bank (ECB) released a report on The State of Climate and Environmental Management in the Banking Sector. In its report, the ECB requested 112 European financial institutions self-assess their current practices against 13 supervisory expectations and provide an implementation plan to address climate and environmental risks and increase transparency in their risk disclosures.
The supervisory expectations are outlined as follows:
Institutions are expected to understand the impact of climate-related and environmental risks on the business environment in which they operate, in the short, medium and long term, in order to be able to make informed strategic and business decisions.
When determining and implementing their business strategy, institutions are expected to integrate climate-related and environmental risks that have an impact on their business environment in the short, medium or long term.
The management body is expected to consider climate-related and environmental risks when developing the institution’s overall business strategy, business objectives and risk management framework, and to exercise effective oversight of climate-related and environmental risks.
Institutions are expected to explicitly include climate-related and environmental risks in their risk appetite framework.
Institutions are expected to assign responsibility for the management of climate-related and environmental risks within the organizational structure in accordance with the three lines of defense model.
For the purposes of internal reporting, institutions are expected to report aggregated risk data that reflect their exposures to climate-related and environmental risks with a view to enabling the management body and relevant sub-committees to make informed decisions.
Institutions are expected to incorporate climate-related and environmental risks as drivers of existing risk categories into their existing risk management framework, with a view to managing and monitoring these drivers over a sufficiently long-term horizon, and to review their arrangements on a regular basis. Institutions are expected to identify and quantify these risks within their overall process of ensuring capital adequacy.
In their credit risk management, institutions are expected to consider climate-related and environmental risks at all relevant stages of the credit-granting process and to monitor the risks in their portfolios.
Institutions are expected to consider how climate-related events could have an adverse impact on business continuity and the extent to which the nature of institutions’ activities could increase reputational and/or liability risks.
Institutions are expected to monitor, on an ongoing basis, the effect of climate-related and environmental factors on their current market risk positions and future investments, and to develop stress tests that incorporate climate-related and environmental risks.
Institutions with material climate-related and environmental risks are expected to evaluate the appropriateness of their stress testing with a view to incorporating these risks into their baseline and adverse scenarios.
Institutions are expected to assess whether material climate-related and environmental risks could cause net cash outflows or depletion of liquidity buffers and, if so, incorporate these factors into their liquidity risk management and liquidity buffer calibration.
For the purposes of their regulatory disclosures, institutions are expected to publish meaningful information and key metrics on climate-related and environmental risks that they deem to be material, with due regard to the European Commission’s Guidelines on nonfinancial reporting: Supplement on reporting climate-related information.
Additionally, the ECB provided the following “good practices” for European Institutions to consider:
utilizing "double materiality" assessments, where institutions consider both financial materiality and environmental materiality;
managing C&E risks through qualitative statements and quantitative indicators;
integrating C&E risks into reporting practices;
including C&E-related criteria in sector and investment policies; and
performing stress testing using a defined baseline to assess physical and transitional risks.
Although this ECB report applied only to European financial institutions, it comes at a time where there is great public discourse surrounding the impact on the environment by financial institutions and the responsibility that such institutions should take on. As such, U.S. financial institutions could benefit from reviewing the ECB's report and comparing the supervisory expectations and “good practices” against their institution's practices.
For questions or concerns about how this report could impact your financial institution, please contact Kennedy Sutherland.