Financial institutions and their investors are flying blind into the climate transition

• The European Central Bank’s supervisory assessment of metrics and disclosures on climate risk at European banks found significant gaps throughout the banking system
• Banks have been developing their capacity to analyze climate risk, but have lagged regulatory expectations based on the pace at which climate-related risks are growing
• Other trade and monetary policy-related issues will help to quickly spread the risks seen in European banks to other parts of the world

The European Union has been among the most active regions in creating disclosure regulations relating to ESG, green finance and climate risks. However, a new supervisory assessment of European banks by the European Central Bank comes to a blunt conclusion:

“The stocktake published on 27 November 2020 demonstrated that virtually none of the institutions in the scope of the assessment would meet the minimum level of disclosures set out in the ‘ECB Guide on climate-related and environmental risks’ published on the same date… For the second year in a row, the analysis showed that virtually none of the banks disclose all the basic information on climate-related and environmental risk that would align with all of the ECB’s expectations.”

The ECB did acknowledge that some progress has been made on certain elements of the climate risk disclosure in its guidance, but many of the areas where progress was found were on high-level governance and risk identification. There is a significant gap between the generalized disclosures, for example, of banks disclosing Scope 1, 2 and 3 emissions (which 74% of banks do) and the far smaller number (15%) who “disclose (some of) their financed emissions”.

Disclosures based on the underlying definitions and criteria used to make specific disclosures was only found complete for 21% of banks, and just 12% of the banks disclose metrics on their portfolio alignment relating to Paris Agreement or Net Zero targets. This slow pace of progress is occurring even as climate-related risks continue to multiply. In some cases, the impact of transition-related climate risks is being magnified by the impact of risks that have materialized through Russia’s invasion of Ukraine, with energy prices rising sharply and volatility growing across commodity markets.

Even as the pace of capacity at the bank level is moving more slowly than regulatory expectations, the ECB is looking further ahead at how climate-related risks are influencing its own activities. ECB Executive Board Member Isabel Schnabel outlined a few of the macroeconomic issues that are influencing its evaluation of future monetary policy, around three countervailing factors.

The first factor is the physical impact of climate-related events on the economy and on prices and inflation. The second is the high level of price volatility relating to fossil fuel energy that would be mitigated by lower dependence on fossil fuel. The third is the inflationary impact that will come as a result of the transition itself through, among other things, significant investment in climate mitigation and adaptation, including on green technology whose production is more commodity-intensive.

The interplay between these factors will affect future monetary policy, which will in turn impact banks and investors, just as monetary policy has since the onset of the Financial Crisis in 2007. One particularly important channel will be the ways that climate-related considerations affect what was previously unconventional monetary policy. Schnabel mentions specifically the lack of disclosure about green assets making ‘green refinancing’ (TLTROs) operationally difficult, and the impact in capital markets when the ECB decides on changes to the market neutrality principle, such as to “actively tilt our portfolio towards the Paris objectives”.

It’s been no secret that regulators are becoming more interested in the financial stability implications of climate change, and that they are preparing to respond through both their own activities and their expectations of financial institutions that they regulate. The analytical framework they are using to understand the supply- and demand-side influences of different elements of climate change has progressed.

At the same time, policies that would internationalize European policies, such as the Carbon Border Adjustment Mechanism, are moving towards adoption. Based on current European carbon prices of $75–100 per ton of GHG equivalent emissions, efforts to internationalize this policy would have substantial impacts well beyond Europe’s boarders.

First, all of the multifaceted links between climate change and growth & inflation will have a direct impact on financial institutions everywhere in the world, and one that will vary country-to-country and bank-to-bank. Second, the monetary policy response function will impact how investors combine macroeconomic and company-specific forecasts and how they value companies and assess their riskiness.

All of these get back to the issue of disclosure and metrics that the ECB’s supervisory assessment looked into. The increase in economic risk from physical and transition-related climate risks is accelerating more quickly than the capabilities to quantify and respond to this risk from the financial institution perspective. A shortfall in this respect occurring within Europe probably indicates similar issues in other countries’ financial sectors.

The RFI Foundation has been working to help fill some of the gaps facing financial institutions and investors in the Islamic markets by exploring the interconnectedness of transition-related climate risks throughout the financial system. In addition, our research has highlighted parallel opportunities for Islamic finance to have a deeper understanding of how to integrate ESG, and where investors can identify, and more importantly, engage with investees on improving resilience to ESG risks, including climate change.

These RFI projects cannot be the be-all end-all in terms of the data and capacity that financial institutions and investors in Islamic markets will need. However, they are starting points to catalyze other actions to drill down, quantify and increase the precision of measurements by every financial institution and investor. They provide a starting point to help accelerate a focus on the issues that regulators have started focusing on themselves in supervisory assessments, which is likely to continue to rise in their priority as the impacts of climate change and the transition pick up pace.

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