Climate & Environmental Risk in Banks

Author: Alex Konewko

An immersive supervisory approach to the management of climate-related and environmental risks in the banking sector

In 2020 the European Central Bank (“ECB”) issued its first guidelines on Climate-related and Environmental risks [1] (“C&E” risks) and has outlined how they will play a prominent part in its supervisory agenda for 2022.

C&E risk now forms an integral part of the annual supervisory review and evaluation process. ECB supervisors will further assess the progress of systemic banks in integrating C&E risks into their business models and internal governance. A thematic stress test [2] specifically dedicated to climate change commenced earlier this year. Similar exercises are likely at a national level by local supervisors in future cycles.

Climate-related and environmental risks, whilst an important component of Environmental Social and Governance (“ESG”) principles, are being evaluated against specific guidelines by supervisors, who expect C&E risk to be a standalone risk pillar within banks.

It is a positive step that European supervisors are helping to necessitate change on such an important issue by assessing the vulnerabilities the risks present to the banking sector. Banks are generally low direct contributors to C&E risks. However, many large banks have been the enablers of climate-related and environment risks, having played a pivotal role in providing the metaphoric fuel to some of the largest negative contributors, by arranging and providing finance.

The supervisory expectation that banks intensify C&E risk efforts is a generational change to the industry. The supervisory assessment of how well banks measure and manage C&E risks when servicing and providing financing activities can only be seen as positive over-time. Albeit banks alone cannot achieve all that is needed to successfully reverse climate change and reduce negative environmental impacts. Such measures will take time to evolve and be embedded further by banks.

Supervisors are also keen to avoid knee-jerk reactions by banks when implementing these guidelines. During a keynote speech [3], Frank Elderson, Member of the Executive Board and Vice-Chair of the Supervisory Board of the ECB stated that “banks should not misconstrue the ECB’s actions as an outright call for divesting from carbon-intensive activities or from geographical regions vulnerable to physical risk. Rather, we are asking banks to fully grasp the risks and to actively start managing them.”

What should we expect to see change?

We can certainly expect to see ‘green’ products and services taking a more prominent role in the range of products being offered by banks over the coming years.  This will include a broader range of ‘green’ lending initiatives from banks with more creative incentives around ‘green’ eligibility criteria. What will be more challenging for banks will be how to provide financial assistance to those who need to improve the energy efficiency of their homes or businesses, where certain customers have limited borrowing capacity or reduced access to credit. This is where collaborative initiatives, potentially involving the support of development banks or utilising government guarantees to support lenders may be needed to expedite more inclusive financing schemes.

Banks will also need to promote their own climate and environmental initiatives with more marketing campaigns on the subject. This will extend beyond purely marketing green products and will include more coverage of extensive ESG initiatives that all institutions will need to commit to undertaking. Likewise, already lengthy financial disclosure documents will also get even longer, as banks include reporting on this topic.

Should guidelines be appropriately implemented, we shouldn’t see a complete withdrawal of funding support for ‘dirtier’ or less-green activities overnight, for example. However, we may start to see some banks distancing themselves towards certain business activities as they re-draw risk appetite thresholds for “no-go” areas. We may also see additional risk premiums, such as carbon offsetting levies, added to the costs of banking services with higher C&E risks.

New data requirements and greenwashing risks

It is behind the scenes where banks are likely to be making the most significant changes, specifically relating to data and internal governance. These areas will require further investment, particularly in defining and building the architecture needed to support the gathering and production of data related to C&E risks. Many definitions of C&E risks are still being debated and the data requirements are far from being standardised.

Greenwashing is the risk of conveying false or misleading information about how a company’s products are more environmentally sound. Even with the right intentions, with poor data governance, ‘accidental’ greenwashing is a real risk banks can face during this transitionary phase. The consequences of greenwashing, accidental or otherwise, are not pretty. Which means we should all expect the level of information banks will need to know about how customers operate, spend, save, invest and borrower money will become even more important.

Long-lasting opportunity for positive change

The outcomes of an ECB thematic review in early 2021 concluded there is still a considerable way to go for banks in developing their C&E risk capabilities. The review highlighted that bank’s reported 90% of their practices are “only partially or not at all in line with ECB supervisory expectations”.

Considering the importance, urgency and long-lasting nature of climate change, the ECB are asking banks to intensify their efforts in measuring and managing C&E risks. For those banks that embrace this challenge, the opportunity for long-lasting positive change is significant.

Alex Konewko is an Affiliated Consultant with ARQ Group specialising in risk, financial services, ESG, and sustainability. Mr Konewko is a former Executive Director and Chief Risk Officer of MeDirect Bank (Malta) Plc, as well as previously holding various Senior Risk Management roles with HSBC in the UK, with over 20-years international experience in banking.

[1] https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr201127~5642b6e68d.en.html

[2] https://www.bankingsupervision.europa.eu/press/pr/date/2022/html/ssm.pr220127~bd20df4d3a.en.html?utm_source=ecb_twitter&utm_campaign=220127_pr_climate_stress_test

[3] https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220218~c55e646426.en.html