The ECB has identified the physical and transition risks of climate change as a key priority for 2020. Banks would welcome any new taxonomies that could clarify green finance terminology when dealing with investors and investees. The ECB has yet to identify any supervisory expectations, but dialogue with other key bodies is ongoing – these risks are unlikely to disappear any time soon.
The UN Climate Action Summit of September 2019 and the rapid acceleration of many sectors’ practical responses are just two signs of a growing global consensus that climate change is a key political, social and economic topic that affects all of us. As individuals we are increasingly mindful of the environmental aspects of our daily life, from daily commuting to the recycling of our consumables. But we have probably given less consideration to how climate change could affect banks, let alone banking supervision.
In their Supervisory Priorities for 2020 the ECB has again identified climate change as a key risk that affects banks, becoming more relevant over the longer-term horizon of more than three years. In this document the ECB states that “Banks should adequately integrate these risks into their risk management framework”. But what exactly are climate change related risks? How do they affect banks? And what are the challenges and responses for supervisors?
In a recent interview Frank Elderson, Member of the Supervisory Board of the ECB and Chair of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), discussed the two major types of climate change risk: physical and transition. Examples of physical risks to banks include damage to investments or collateral, such as buildings destroyed by flooding or crops damaged by extreme weather. Transition risks can occur as a result of the transition towards a low-carbon economy, for example by shutting down coal mines or adjusting transport infrastructure.
As further discussed in the recent Eurofi conference in Helsinki, these risks are not limited to individual countries. It is becoming more and more clear that addressing these banking risks not only calls for cross border cooperation, but also for collaboration between legislators, banks, regulators and supervisors.
In response, the European Commission is in the process of legislating for a European Green New Deal, with the aim of making Europe the first climate-neutral continent. A recent publication (PDF 1.35 MB) from KPMG’s Regulatory and Risk Insight Centre in London discusses how a Sustainable Europe Investment Plan is providing a full regulatory agenda to address climate change. This includes the drive to establish a framework to facilitate sustainable investment by developing legally-binding standards for sustainable finance (PDF 525 KB) through enhanced disclosures. Creating definitions and standards for green finance should make it easier for businesses to attract capital for sustainable investment from across Europe, and to compare their green credentials in a more consistent manner.
Banks are evidently considering how climate change could affect their strategy, internal governance, risk management, as well as the positive ways in which legally-binding standards could have on their own disclosures, as well as on their business practices. There has already been a shift in attitude; for example, in recent years banks have announced such measures as, that they will no longer funding new coal projects, investing in more green bonds and looking at the social impact of green energy investments.
With this in mind, banks are receptive to the creation of agreed taxonomy for climate-change products that would help not only consumers to make decisions over sustainable investments, but also give banks the data that would foster comparability on green finance – something that would reduce the current requirement to perform individual, extensive due diligence on investments that claim to offer green credentials.
As yet, there are no official pronouncements from the ECB on their supervisory expectations on climate-change risk, or guidance on how banks can adjust towards these physical and transition risks. However, by including climate-related risks as one of the key risks to banking in their Supervisory Priorities for the second year running, the ECB has shown a clear desire to engage with banks to understand how they are incorporating climate-related issues into their risk-management systems. The ECB is also continuing their dialogue with National Competent Authorities on this topic, taking note of how best to move forward. Upcoming actions by the Bank of England, such as Climate Change Stress Tests in 2021 could also give food for thought for other NCAs in the EU.
Regarding upcoming actions, the point of the view from the industry is that any taxonomy on sustainable finance should be easy to implement whilst remaining flexible; banks understand that we are likely to have a better understanding of climate science in future years, so definitions and concepts should be adaptable. However, banks welcome data that could simplify climate-related matters for customers, investors and shareholders.
More broadly, as the ECB has amply demonstrated, dialogue between European institutions, NCAs, banks and legislators must continue, ensuring that everyone works together against a risk that affects us all.